What is Loan Prepayment?
Loan prepayment means making extra payments beyond the required monthly amount to pay down the principal faster. Since interest is calculated on the remaining principal, every dollar of extra payment eliminates all future interest that would have accrued on that dollar. This is compound interest working in reverse, benefiting the borrower instead of the lender.
Term Reduction vs. Payment Reduction
Prepayment can be applied in two ways. Term reduction keeps monthly payments the same but shortens the loan duration, saving more total interest. Payment reduction keeps the term the same but lowers monthly payments, improving cash flow. On a $200,000 mortgage at 4% with 25 years remaining, a $10,000 prepayment saves approximately $15,000 in interest with term reduction versus $7,000 with payment reduction.
When to Prepay vs. Invest
The decision hinges on comparing your loan rate to expected investment returns. If your mortgage rate is 3% and you expect 7% from stocks, investing the extra money yields a higher net return. However, investment returns are uncertain while interest savings from prepayment are guaranteed. Always maintain an emergency fund before making extra payments, and check for prepayment penalties in your loan agreement. Tax deductions on mortgage interest may also affect the calculation.