The power of prepayment

keep-calm-and-save-your-moneyDo you know how powerful mortgage prepayments can be? They do two things: save substantial interest costs and shorten the life of your mortgage (the amortization). You typically have two prepayment alternatives, monthly or annually. The annual option allows you to make lump sum prepayments, typically from 10-20 per cent, of the “original” loan amount. Calling this prepayment option annual is somewhat misleading since you can now typically plunk down your lump sum prepayments on any regularly scheduled mortgage payment date. However, the maximum allowed prepayment is still tracked annually.  If you pay your mortgage biweekly, that’s 26 times a year you can prepay. The monthly option allows you to increase your regularly scheduled mortgage payment, from 10-to-100 per cent. Again, if you pay your mortgage more frequently (e.g. biweekly), the increased payment can be more than twelve times a year.

UNDERSTANING AMORTIZATION

For an amortized loan, every payment consists of an interest component and a principal component. Most borrowers prefer a fixed-rate of interest, and a constant payment. Over time, the interest component will shrink and the principal component will increase, but the payment remains constant. At the beginning of the amortization period, when the amount of the loan is biggest, most of the constant payment will be interest. Later in the amortization period when the interest component is lower, a greater portion of the constant payment is applied to the balance owing. The chart below illustrates the impact on a monthly basis. In year two, the interest component is much higher than in year 20.

Date  

Principal

portion

Interest

portion

Total

payment

         
Year 2 Jan

$100

$800

$900

Feb

$101

$799

$900

Mar

$102

$798

$900

Year 20 Jan

$585

$337

$900

Feb

$588

$332

$900

Mar

$573

$327

$900

Assumes fixed interest rate, an original $100,000 loan, and no prepayments

 

THE EARLIER YOU START PERPAYMENT THE BETTER

The impact of making prepayments on your mortgage is much more significant in the early years. While this is usually the heavy borrowing period in the lives of most people and finding extra cash is difficult, virtually any amount of prepayment makes a considerable difference. That’s because the early scheduled payments are mostly interest. Your prepayments will effectively leapfrog the early high-interest payments. To illustrate this in the chart below, see what happens to a $100,000 mortgage amortized over 25 years when you make a single, one-time prepayment of $1,000. Without listing every year, I have arbitrarily picked years 1, 9, 15, and 23 to show the dramatic difference on when you decide to make the $1,000 prepayment.

Amortization

Year

Savings

1

$9,780

9

$4,110

15

$1,875

23

$325

Clearly, the chart shows the sooner you make the one-time $1,000 prepayment the more interest you will save. (Source of above two charts: CIBC)

Finally, consider the impact of increasing your monthly payment. On a $300,000 mortgage at 3%, amortized over 25 years, the monthly payment is, $1,419.74. If you could round the payment up to an even $1,500, you would shorten your amortization almost two years, and save over $10,000!

The bottom line is there are dramatic savings to be found if you can make prepayments against your mortgage. The key is to put yourself in a position to take advantage. Sadly, there are too many people who use very little, or none, of this opportunity to save money. Make sure your mortgage advisor gives you the guidance you need when taking on this kind of debt.

If I can help, let me know.