The repayment of principal on a mortgage is an investment that
yields a return equal to the interest rate on the mortgage. In
other words, the lower your principal balance, the less interest
you're paying. If you make additional payments, you save the
interest on that amount of money.
Let's say, for example, you add $100 to your normal monthly
mortgage payment. This makes your loan balance at the end of the
month $100 less than it would have been without the extra
payment. In the months that follow, you save the interest on
that $100 that you otherwise would have paid.
Since the interest payment that you would have made is
determined by the interest rate on your mortgage, the yield on
your $100 investment is equal to that rate. A prepayment
penalty, however, would reduce the yield. Always make sure your
loan does not penalize you for paying early.
To determine whether paying more principal is a good investment,
the interest rate should be compared to the yield on alternative
investments having minimal risk. Why? There is zero risk on loan
If your mortgage rate is 6 percent and the alternative yield is
a 3 percent earned in a savings account, for example, your
future wealth will be greater if you use your excess income to
repay principal rather than putting it in the bank. After any
period, the reduction in the loan balance would be greater than
the increase in the bank account.
If you can safely make a greater return elsewhere, though,
invest your money there instead of paying down your mortgage.
Before making any decision on your financial future make sure
you see the numbers in black and white and get printouts of all
your different scenarios.
About the author:
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