What are the purposes of my mortgage prepayment

Do I really need to know more about prepayment?

Prepayment of your mortgage loan has two purposes:

shortening the term; and,
allowing you to pay less interest.

The way prepayment was traditionally made was by paying the exact amount of principal for your next payment along with your current payment. If you had 300 payments left on your loan, your current payment would bring you down to 299. If you paid payment 300 plus the principal reduction amount on payment 299 at the same time, you would then have 298 payments remaining.

This was an easy way to figure out how much to pay and how many months you would have to pay to pay off the loan. The greatest advantage in prepaying your loan was during the early years of your loan. This was when the amount going to principal was lowest and the interest amount was highest. If your payment was US Dollars 1,000 per month early in your loan, perhaps only US Dollars 100 was going to principal and US Dollars 900 to interest on your current payment. Your next payment might have US Dollars 110 going to principal. By prepaying the US Dollars 110, you saved US Dollars 890 in interest. Late in your loan the opposite would be true - US Dollars 900 would go to principal and US Dollars 100 to interest. You would have to make a very large additional principal payment to save a small amount of interest. It simply is not a good option.

Rates can go up just as fast.

You can see the obvious advantages, but there are also risks. First, by getting an additional loan, you are taking on an additional required payment. If you have future financial difficulties, this could become a burden. Second, the equity line of credit may only be available with an adjustable rate. This could raise your payment amount if rates increase and lessen the advantage. Both risks seem manageable and well worth taking to realize the savings. The last consideration for our example is what else you could do with the extra money each month. There is no safe investment in today's market that equals a rate of return even close to prepaying your mortgage loan, especially if you eliminate the PMI payment.

By the time you read this, PMI may be tax deductible. Check with your tax adviser. Another possibility is to borrow against your 401(k). However, this is usually not a good idea for several reasons.

You are borrowing from yourself. The money you borrow will not be earning retirement income for you. Since many employer-sponsored retirement plans have employer contributions, this could be a significant loss.
If you leave your job, you will have to pay back the loan in full. This could cause you to stay with your current employer and pass up a better opportunity.
Under current law, you will have five years to pay back the loan. If you fail to do so, you will incur a penalty of 10% of the amount owed, plus you will have to pay income tax on that amount.

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