Mortgage Prepayment

Amortized mortgages work by requiring a monthly payment, designed to allow the mortgage to pay off completely at the end of the loan’s term. For some loans, it may make sense for borrowers to make early payments to reduce the loan’s balance and thereby shorten the amount of time it takes to pay off the loan.

Prepayments work differently with adjustable rate mortgages (ARMs) than with fixed rate mortgages. With an ARM, prepayments reduce the monthly payment amount after the rate is adjusted, but do nothing to shorten the loan’s pay off time. Fixed rate mortgages, on the other hand, will always have a constant monthly payment, but allow you to pay off the loan early through additional payments applied to principal. In this section, we will focus on the advantages of making these payments on a fixed rate mortgage.

When determining if paying early on your amortized fixed rate mortgage is a good investment for you, you should compare the money you will save to the return you would get if you invested the money elsewhere. The return for an investment in prepayment is equal to your mortgage’s interest rate.

If you make an early payment of $100, you will save the interest you would have paid on the $100 in the following months. This return should be compared to the amount you would earn by investing your money elsewhere, and depends largely on your other potential investments and your mortgage’s interest rate.

The comparison is fairly straightforward, but there are some factors that can make it more complex. If you have prepayment penalties for early payments on your mortgage, you of course should factor these into the calculation. They will likely dissuade you from making early payments, which is their purpose.

If you are considering a tax-free investment opportunity, make sure to calculate the return on your mortgage prepayment investment in after-tax dollars for a true comparison.