NEW YORK (TheStreet) -- Mortgage rates have stayed low far longer than most experts had expected, and could just stay this way for, well, some time. Does it make sense, then, for homeowners to make extra principal payments? And if it does, what's the smartest strategy?
A prepayment is a payment above what's required for a given month. It reduces the principal, or loan balance. Owing less, the homeowner is then charged less for interest. That means more of each future payment goes to principal rather than interest, reducing the balance even further for a snowballing effect. Over time, this can reduce interest charges substantially, and by reducing the debt faster it speeds the building of equity, the difference between the home's value and the loan balance.
So every prepayment, whether a large lump sum or a small amount kicked in every month, is a kind of investment. The return is equal to the loan rate. If you pay 4.5%, each $100 in prepayment saves you $4.50 a year in interest, just like earning 4.5% in a savings account.
You could save nearly $21,000 in interest by paying an extra $100 a month on a 4.5% mortgage, assuming a $200,000 balance and 25 years to go.
It's easy to see that this investment is more profitable when loan rates are high -- 7% or 8% rather than 3% or 4% -- but prepayments can still pay off under today's relatively low rates. Whether a prepayment makes sense depends on what you could earn in another investment. Stocks, of course, can pay much more in the good years, but come with lots of risk. So prepayments are typically compared with other investments, such as bank savings or short-term bonds, that that have guaranteed yields and little risk. With the average five-year certificate of deposit yielding only about 0.75%, a prepayment earning 4.5% looks pretty generous.
But money used for a prepayment is tied up in the home. To get it, you have to sell or take out a loan, so a prepayment is a long-term investment. And during that time alternatives such as CDs could become more generous. That's one of the unknowns you face.
There are some other factors, too. By paying down your mortgage balance, you make yourself a better candidate for other loans in the future -- car loans, home equity loans, loans for a child's education.
A prepayment makes sense only if you have a good rainy-day fund, and generally only if you've already put the maximum into tax-favored investments such as a 401(k), especially if the employer matches your contribution. To see the benefits, use a Mortgage Payoff Calculator.
Generally, prepayments are credited on the next monthly payment's due date, so there's no real benefit in doing them much earlier than that, says Jack M. Guttentag, emeritus finance professor at the Wharton School.
Though some homeowners think prepayments pay off better in certain months, such as January, that's not so, Guttentag says on his website, The Mortgage Professor. Of course, starting earlier pays, because you would thereby reduce interest payments for longer.
A homeowner with a second mortgage, or with mortgages on more than one property, should prepay on the loan with the highest interest rate, he adds, unless one of the loans as a variable rate. Prepaying on that one, even if the current rate is lower, could pay off better if that loan adjusts to a higher rate later.
People with more than one property should also weigh the potential for future refinancing, he says. For example, a prepayment on one property might allow you to get the debt down to 80% or less of the property value, eliminating the need to pay mortgage insurance. You might want to wrestle this debt down first, even if another loan had a higher interest rate.