If you have a mortgage, you should take a few minutes to study your amortization schedule. You might be surprised to see how powerful prepaying your mortgage might be. In fact, prepaying your mortgage may provide a 129% return on investment.
To see how this might be, we have to work through a few numbers. Please take a minute or two to understand the numbers in this article. I promise it will be worth your time, because what you see will probably be similar for your mortgage.
Below is an ugly screen shot for a mortgage on a 24-unit apartment building in South Euclid:
Click on the image to enlarge.
The total monthly mortgage payment for this property is $4,067, which includes principal and interest. The left column shows the portion of the payment allocated to interest each month. The next column shows the portion of the payment allocated to the principal each month. The column on the far right shows the outstanding principal balance after each monthly payment is applied. You can see the annual totals for each column in bold for 2015 in the bottom row.
In the book “Wealth Without Risk” by the late Charles Givens, he recommended the following:
“On the first of the month when you write your regular mortgage check, include an additional payment equal to the principal portion of the next month’s payment.”
This recommendation would allow anyone to pay off their entire mortgage in half the time. In the amortization schedule above, this investor would make their regular December 2014 mortgage payment of $4,067 plus the principal portion of the payment for January 2015 of $1,211.53.
This loan has 272 remaining payments (22.6 years) according to his amortization schedule. By following this prepayment plan, the investor will shave 136 monthly payments off of the mortgage and will have this apartment complex paid off in full in 11.3 years. At this point, he’ll add $4,067 to his monthly cashflow and will remove $551,485.20 of future monthly payments.
Let’s take a closer look at the amortization schedule to see what really happens when this prepayment is made. The amortization schedule is where we’ll find gold.
If, in December 2104, this investor did make the extra principal payment for January 2015 of $1,211.53, he would completely eliminate this payment from the amortization schedule as the outstanding principal balance would drop down to the outstanding balance AFTER the January 2015 is applied of $636,398.76.
If we look at this month of January 2015, we’ll see that his additional prepayment in December 2014 actually removes the interest portion of the January 2015 payment. This means his $1,211.53 additional principal prepayment in December saves him $2,855.96 of interest.
Please read that again. It’s BIG!
Who wouldn’t want to invest $1,211.53 for a guaranteed of $2,855.96? This is a guaranteed 135.7% return on the investment.
In fact, if this investor were to make one lump sum principal prepayment of $14,801.90, which represents the total principal to be paid down in 2015, he would save $33,907.99 in interest. (Refer to the bold totals for 2015.) This lump sum prepayment would move him down to January 2016 outstanding principal balance in the amortization schedule.
This would be a 129% guaranteed annual return on his investment calculated as follows:
Total interest saved $33,907.99
Less principal prepayment of ($14,801.90)
Gain on investment (actual interest saved) $19,106.09
ROI (Divide the Gain by Amount Invested) 129% ($19,106.09 divided by $14,801.90)
Believe it or not, prepaying a mortgage offers an incredible investment opportunity for us. The problem is we’re never taught this in school. Instead we’re taught that the interest rate on the mortgage is the most important number. The interest rate is important, but understanding how the amortization schedule works is the most crucial part of any mortgage.
For the first 17 years of any mortgage, the majority of each payment is allocated towards interest. It doesn’t matter what your interest rate is. If you study each independent monthly mortgage payment and how it is allocated between principal and interest, you’ll see how much you’re really paying for the loan. If you don’t believe me, dig out your amortization schedule and check it out. Or create a new one online using an amortization calculator using your starting mortgage amount and your interest rate. Study each monthly payment and calculate what percentage of the payment is going to interest.
The investor who owns this property wanted to prepay the mortgage as outlined in this article. However, he didn’t want to pay out of his pocket. So we worked to increase the monthly positive cashflow generated by the property. This was accomplished through rent increases, new income streams, and expense reduction. He is using the higher monthly cashflow to prepay the mortgage. In other words, he engineered the income from the property to accelerate the mortgage prepayment. This is a very smart strategy.
A challenge for you in 2015…
See if you can create enough monthly passive income to make your monthly prepayment as suggested by Charles Givens. Take a look at your amortization schedule and look at the portion allocated to principal in your next month’s payment. See if you can create an income stream you might use to prepay the following month’s principal in the current month. Your passive income will then pay your mortgage off in half the time.
NOTE: This return on investment and the amount of interest saved decreases as the principal balance is paid down and more of the payment is allocated towards the principal. At some point, you’ll reach the crossover point (around 17 years) where more of your monthly payment is allocated to principal balance than to interest. Your return on investment at this point will be significantly less with each prepayment.