According to Black Knight’s monthly Mortgage Monitor, prepayments more than doubled in the 12 months leading up to October 2019 and are now at their highest point since May 2013.
What is Driving This Wave of Prepayments?
A prepayment is a payment above just the regular payment required by a lender for a given month. Each payment reduces the borrower’s loan balance, which in turn reduces the amount of interest the lender can collect. By paying above the usual payment, a borrower saves money on future interest payments.
According to Black Knight, the wave of prepayment activity seen in 2019 is linked to falling interest rates. Given the Federal Reserve’s latest announcement that it intends to hold interest rates steady in 2020, one could assume prepayment activity will continue in 2020. But in reality, the reasons for making a prepayment are more complex than just looking at whether interest rates are high or low. As with many personal finance decisions, it really depends on each borrower’s own particular set of circumstances.
When are Prepayments a Good Idea?
Logic dictates that prepayments are actually more beneficial when rates are high—so, it makes more sense to prepay if you’re carrying around the 6%-7% rates that were the norm before the 2007-8 financial crisis than if you borrowed at a rate in the current 3%-4% range. That’s because the higher the interest rate, the more you stand to save by reducing the amount of principal on which your lender can collect interest.
Actually, the best way of looking at a prepayment is as an investment. And what should you do before you make an investment? Compare it to other investments, and try to predict which one will offer the greatest return. As TheStreet, a popular financial literacy website, advises, if you stand to save more from your prepayment than you would gain from an alternative investment (e.g. stocks, bank savings, or short-term bonds) then a prepayment is the correct choice. But if you stand to earn more from an alternative investment, then it makes more sense to stick to your regular mortgage payments and put your money to better use elsewhere.
This mortgage prepayment calculator can help you compare prepayments to other investment options. Let’s say you have $100,000 principal and 15 years remaining on your loan and that your interest rate is 5%. Now let’s say you were willing to pay $1,000 per month instead of the usual $790.79—an additional $209.21 per month. In this example, you would earn $12,714 in interest savings and pay off your mortgage in 10 years, 10 months (130 months).
Using this compound interest calculator, we see that for a $209.21 monthly investment over 130 months, you need an annual interest rate of 6.65% to earn $12,714. So, if you were the borrower in this example, you would need to ask yourself whether another investment could give you a greater earning. You also need to compare risk: that’s because a prepayment is a guaranteed return, whereas some alternative investments, such as stocks, are high-risk investments where you could easily earn or lose more than you expect.
Other Things to Think About Before Prepaying
Of course, deciding whether or not to prepay requires you to conduct a thoughtful analysis of your financial situation. You’ll need to consider things like what percentage of your income you are willing to put into prepayments, how long you are planning to stay in your home, and whether refinancing might be a better option.
It’s also worth taking these factors into account:
- Prepayment penalties. A prepayment penalty (also known as an early payment penalty) is a penalty written into your mortgage contract which protects the lender against prepayment risk (i.e. the risk that you pay off your mortgage early, depriving the lender of a portion of the pre-agreed interest payments). As a general rule, penalties tend to be heaviest early on in the loan term (years 1-5) when the lender is at greatest risk. With that said, prepayment penalties really do vary from lender to lender, so it is absolutely essential that you check what is written into your contract.
- Loss of tax benefits. No one likes to pay interest, but at least you can write it down as a tax deduction. Basically, homeowners must meet 2 basic requirements to qualify for a mortgage interest rate tax deduction: you must have filed an IRS form 1040 and itemized all your deductions; and your mortgage must be secured by your primary residence or second home. According to IRS rules, you can deduct home mortgage interest on the first $750,000 of indebtedness (or $375,000 if married, by filing separately). That covers most American homeowners.
- Private mortgage insurance (PMI). Although prepayment penalties tend to be highest early in your mortgage, there is a benefit to starting prepayments in years 1-5 if it means ridding yourself of PMI payments. Private mortgage insurance is a requirement of loans with less than 20% down payment, such as FHA loans, VA loans, and low-down payment conventional loans. By making early prepayments on such loans, you can get to 20% equity quicker—and earn the right to stop paying monthly PMI.
Comparing Your Prepayment Options
Deciding whether to prepay is similar to deciding which lender to choose for your mortgage: the question is best answered by comparing. When you first buy your home, it is worth doing a comparison shop between lenders. And when you think about prepaying, it makes sense to compare to alternative investments and weigh up the pros and cons. Our last piece of advice: if you are in the market for a new mortgage or refinance, it might be worth checking in with your lender’s prepayment policy at this early stage so that you know what to expect in the future.