Posted by Mike Smith :: October 4, 2007 @ 6:25 am

In my recent post about amortization, I discussed the different categories of repayment. I also mentioned that prepayment, when permitted by your loan, is an excellent way to save money by shortening the loan term. I’d like to expand on that topic and give you an example of the impact prepayment can have.

For the purpose of this post, let’s assume that you have a 30-year mortgage for $300,000 at 7% interest. I will use my favorite mortgage calculator for the calculations in this post. Using the above parameters, your monthly mortgage payment would be $1,995.91. In the first month, $245 would be going to principal and the rest to interest. By the last month, $1,980 would be going to principal.

The fact that your principal payments are so small, particularly early in the loan term, is the reason why prepayments can be so effective. While putting an extra $5 per month toward your mortgage may not seem like a lot, it can have an impact. $5 is only a small amount of your $1,995 mortgage payment, but it is a much larger percent of your $245 going towards principal. Calculated savings in interest by prepaying $5 a month will amount to over $4,250!

Other prepayment amounts, interest savings, and new loan terms are included in the table below. The table also adjusts savings for inflation, assuming 2% per year.

(Click to Enlarge Graphic)

As was discussed in my post on investing versus paying off debt, extra money should usually be applied to your debt at the highest rate. If you carry a balance on your credit card, the extra money that you have available for mortgage prepayment might be better applied to that debt instead. Along those lines, it is also worth mentioning that there isn’t a general consensus among financial advisors as to whether or not you should prepay your mortgage. While most generally agree with the strategy, they suggest applying available funds to other areas, such as retirement savings, first. Determining the ideal place for extra money is a difficult proposition and one that generally relies on assumptions. Trading off a known cost with a defined saving, such as prepaying your mortgage, against an unknown or assumed alternative, such as a retirement savings account, is no easy task.

As for the potential savings from mortgage prepayment, the table clearly shows how even small prepayment amounts can have a significant impact on the amount of interest that you can save. While these numbers relate to a sample mortgage, they clearly show the benefits of mortgage prepayment. Everyone’s situation is different, but we here at Lending Club believe that mortgage prepayment may be a beneficial strategy to consider for your own personal finance plan.