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Do I really need to know more about prepayment?

This book has touched on prepayment with plans such as biweekly payments, but the subject is important enough to deserve its own chapter. Prepayment of your mortgage loan has two purposes:

1. shortening the term; and,

2. 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 $1,000 per month early in your loan, perhaps only $100 was going to principal and $900 to interest on your current payment. Your next payment might have $110 going to principal. By prepaying the $110, you saved $890 in interest.

Late in your loan the opposite would be true — $900 would go to principal and $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.

What changes in the industry affect prepayment today?

There are two major changes that affect prepayment today. The first is the computer. In the past, the reason you were required to pay the exact amount of principal as a prepayment was that someone had to do the math by hand. Unless you used this easy method, it was very time-consuming for the lender to redo your whole amortization schedule. Now, the computer refigures the amortization schedule in seconds, making the specific amount of the prepayment immaterial.

The second change makes prepayment even more important for some loans. In the old days, you had to put 20% of the loan amount as a down payment and there was no PMI. Today, loans with greater than 80% loan-to-value ratios are common and PMI is required. Prepaying a loan down to 80% not only saves interest, but also allows you to stop paying PMI.

If you are paying PMI and have some money available at the end of the month, making additional principal payments is an excellent investment. Unfortunately, most borrowers who do not have 20% to put down at the beginning do not have extra money with which to make prepayments in the early years of the loan. However, there are other, more sophisticated methods to eliminating PMI.

Example 1: You originally obtained a 90% loan and you have paid it down to 85%. Your income has increased, so you now have a few hundred dollars that you could put into prepayments. Your home may also have increased in value. You should be able to get an equity line of credit at the prime rate or slightly lower. You could use the line of credit to pay your loan down to 80% and eliminate the PMI. Then you would use the extra money you have to make payments on the line of credit loan.

Example 2: You have purchased a home for $200,000 and put 10% down. Your monthly payment on your $180,000, thirty- year loan at 6% interest is $1,079.19 (rounded to $1,080). You have paid down your loan to $170,000 by making required payments, but still need to reduce it by another $10,000 to eliminate the PMI.

If you were to get a home equity line of credit (HELOC) for $10,000 and use the money to pay down your first mortgage, you could eliminate the PMI and save the interest that you would have paid to reduce the loan by making required monthly payments. By making the required payments, you would reduce your loan balance to $160,000 in thirty-nine months and pay over $32,000 in interest for that period. In addition, you would pay a PMI premium of approximately $75 per month, or $2,925, for a total cost to you of approximately $35,000. A reasonable interest rate for an equity line of credit would be less than the interest on your first mortgage loan.

A reasonable interest rate on an equity line of credit would be the prime rate to 1% below the prime rate. Let us split the difference and say 8%. Your monthly payment on a $10,000 loan at 8% for five years would be $202.76 ($203]. Since you eliminated the $75 per month PMI, your out-of-pocket payment would be $128. If you made only the monthly payment required to amortize the loan, your total cost would be roughly $12,180 ($203 x 60]. Of that, $2,166 would be interest.

Note: Even though the above numbers may seem outdated, I have not revised them. They were valid only a few months ago and I want you to understand how quickly things change. 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.

Note: 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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