With the current downturn in housing market, more and more people are realising the importance of having more equity in their homes. While lenders now insist on a Loan-to-Value ratio of 80% or higher, buyers are going for more affordable homes in which they can put in a significant amount of down payment.
Buying a home within one's means is certainly to be encouraged, but there is another way to build more equity into one's home, by prepaying the home mortgage. While some financial advisers are of the opinion that prepaying a mortgage is not a good investment, arguing that the money can be put into better investments with much higher returns (read stocks), the recent wave of foreclosures and the bottoming out of the stock market has brought home another important realisation- the peace of mind that comes with owning a home is as important as chasing higher returns.
Why Make a Mortgage Prepayment?
Consider a $200,000 mortgage at 6% for 30 years. The required monthly principal and interest payment would be around $1,200. If a borrower prepay the mortgage by just $50 from the first month onwards, she would save $27,878.17 in interest and the term of the loan will be reduced by three years. By paying off principal early, a borrower saves interest and reduces the term of the mortgage. The more she prepays, and the sooner she does it, the more time and money she will save. A mortgage prepayment calculator can calculate how much interest can be saved by prepaying a fixed amount every month.
A mortgage prepayment is a risk-free investment. The return on the investment is the interest that a borrower will save when he prepay a mortgage. Supposing that there is no prepayment penalty, principal prepayment yields a return equal to the interest rate on the loan. For a mortgage with 6% interest rate, the return on prepaying the mortgage early is 6%. The yield goes up for mortgages with higher interest rates.
Who will Benefit More with Prepaying a Mortgage?
- Seniors- It is a general rule that the closer a person gets to his retirement, the more conservative his investments should be. Seniors are advised to limit their investments in stock and allocate increasing portions of their resources to government bonds and other conservative investments, but the return on them is most likely to be less than what they get by prepaying their mortgage.
- Borrowers whose interest rate on mortgage is 9% or higher- Repaying a mortgage is an investment with a yield equal to the mortgage interest rate. The higher the interest rate of the loan, the better the yield on it. Again since the investment carries no risk at all, it may be better to pay off the mortgage early than to invest it in a diversified portfolio of stocks with an uncertain return of 12% or higher.
The Mortgage Professor's web site is a helpful source for people looking for information on mortgage prepayment.
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