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When Prepayments Matter

Mortgage-prepayments Most people know that a low rate isn’t everything when shopping for a mortgage.  There are lots of reasons why that’s true.  Prepayment privileges are one such example.

Depending on your disposable income, prepayment privileges may mean a lot or they may mean nothing.  If you have the money to make them, they’re one of the best zero-risk investments you’ll ever find. 

(Prepayments can drastically reduce the interest you’re stuck paying with after-tax dollars. For someone in the 40% tax bracket, for example, a prepayment on a 5% mortgage is like earning a guaranteed 8.33% return.)

For this exercise, let’s assume one has the money and desire to take full advantage of prepayments.  In this case, we’ll turn to Joe P. Borrower who is presently evaluating two mortgage options:

Option A:  A 5-year mortgage at 4.49% with 20% annual prepayment privileges

Option B:  A 5-year mortgage at 3.99% with 15% annual prepayment privileges

(Assumptions: A $200,000 mortgage and 25 year amortization)

Other things being equal, probably 9 out of 10 people would gravitate to option B for the better rate alone.

If you have the means and plans to maximize your prepayment privileges, however, option A will actually save you more money.  Joe Borrower would save about $1858 in interest over 5 years by taking advantage of the additional 5% prepayment privileges in option A.  That’s real cash money.

The point is that a mortgage’s terms can sometimes offset a much lower interest rate. Mortgage professionals add value by explaining these scenarios.  Therefore, if you’re simply sending your application to the lender with the best advertised rate, you might be doing yourself a disservice.


Update: February 6, 2009

Below are two other points that were not in our original article. These points were noted by our helpful readers.

  1. Larger prepayment privileges can also save you money if you break your mortgage contract early (e.g.  when you sell your property outright or refinance).  In such cases, making a bigger prepayment before paying off the mortgage reduces your interest penalty. (Just ensure you make your pre-payment before you request the discharge.)
  2. Some lenders allow prepayments only once a year. This lack of flexibility means you will pay more interest in the interim while you are awaiting your prepayment date.
  3. Citizens Bank has a good prepayment calculator where folks can run their own pre-payment calculations.