There are two major changes in the mortgage industry that affect mortgage 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 US Dollars 200,000 and put 10% down. Your monthly payment on your US Dollars 180,000, thirtyyear loan at 6% interest is US Dollars 1,079.19 (rounded to US Dollars 1,080). You have paid down your loan to US Dollars 170,000 by making required payments, but still need to reduce it by another US Dollars 10,000 to eliminate the PMI.
If you were to get a home equity line of credit (HELOC) for US Dollars 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 US Dollars 160,000 in thirty-nine months and pay over US Dollars 32,000 in interest for that period. In addition, you would pay a PMI premium of approximately US Dollars 75 per month, or US Dollars 2,925, for a total cost to you of approximately US Dollars 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 US Dollars 10,000 loan at 8% for five years would be US Dollars 202.76 (US Dollars 203). Since you eliminated the US Dollars 75 per month PMI, your out-of-pocket payment would be US Dollars 128. If you made only the monthly payment required to amortize the loan, your total cost would be roughly US Dollars 12,180 (US Dollars 203 x 60). Of that, US Dollars 2,166 would be interest.
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.
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