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.