How Do Prepayments Create Mortgage Interest Savings?
When you take out a loan to purchase a home, the monthly payment is based on the number of years you plan to take to repay the loan.
Each month during the life of the repayment, the bank calculates the interest portion of each payment on the total balance of the loan. The interest is then subtracted from the payment -- leaving the amount that is used to reduce how much you owe (principal portion).
This means that if you make a payment over and above the prescribed payment amount ...
This is because each time the bank goes to calculate interest, the amount you will be charged interest on will be lower than what the original payment amount was based on.
In other words, when you add an amount to your current prescribed payment, you haven't just created mortgage interest savings on your next payment, but you also have created mortgage interest savings for every month for the rest of the repayment term.
And this is true for every time you add a prepayment amount to your existing payment.
Even if you only make a single, one-time prepayment, your annual mortgage interest savings will grow over time -- because more and more of each payment is being applied to paying off the home loan.
How to Make Prepayments on Your Next Home
Suppose you've been making payments on a $250,000, 6%, 30-year mortgage for the past 3 years, but you only plan to stay in your home for another 5-years.
If you were able to free up an extra $200 per month to add to your current mortgage payment, 5 years from now you will be able to apply the following prepayments to the purchase of your next home:
- An additional $12,000 in equity.
- $2,000 in interest savings.
That's $14,000 you won't have to borrow and pay interest on!
But wait, if you have high-interest debts and apply the $200 per month to a rapid debt reduction plan, you may be able to double or triple the $14,000 prepayment on your next home.