Written by: Andrew Allen
Edited by: Austin Lang
Reviewed by: Jon McDonald
People who’ve lived long enough have probably heard the idiom, “a bird in hand is worth two in the bush.” If that phrase confused you the first time you heard it, you’re not alone. First of all, who wants a bird in their hand?
It means that it’s better to have something today than to risk losing it for something better tomorrow. If you have the money to pay off your loan debt today, you could face a similar situation. This is called prepayment, which means to pay more money than what you owe (up to the entire balance) before it is due.
Do you try to gain the financial flexibility and peace of mind that comes with being debt-free? Or do you ignore your debt and try to turn your stack of cash into a bigger pile of cash?
A prepayment occurs when you pay a loan in full or make a partial payment before it’s due.
Like most things in life, prepayments have benefits and drawbacks. One drawback is the potential for paying a prepayment penalty, meaning a little extra money if you decide to pay off your entire debt.
Whether you should pay off your loan early is a personal decision that depends on your circumstances and overall money management strategy. I’ve looked into prepayment pros and cons, as well as different types of prepayments, and can give you all the information you need to make a decision you can live with.
How Prepayment Works
Prepayments come in many different forms, and they can change your amortization schedule, which shows you how much each of your payments will be until your loan is paid in full.
Prepayment strategies can differ depending on your goals and financial situation, so I’ll examine the different scenarios for you.
Mortgages
Buying a house is one of the most expensive purchases most of us will make in life. A mortgage can feel like a burden, so it’s reasonable to explore ways to get rid of it ahead of schedule.
You can pay more than what’s due on your mortgage payments each month. For example, if your mortgage payment is $1,500 per month, you could pay $1,600 each time a payment is due. These are technically prepayments.
Let’s say you found a $250,000 home you wanted to purchase today with no money down. If you took out a 30-year mortgage for that sum with an interest rate of 6%, your monthly payments would be around $1,500 (before property taxes and insurance costs).
If you decided to pay just $100 extra ($1,600 instead of $1,500) each month, you could pay off the mortgage in under 26 years and save more than $51,000 in interest.
This is because that $100 is going directly to paying off the principal, not the interest. So while you are making interest-heavy payments in those early years, you still have a $100 secret weapon helping you lower your overall cost. Here it is by the numbers:
| Original | With $100 Prepayment | |
|---|---|---|
| Monthly pay | $1,498.88 | $1,598.88 |
| Total payments | $539,595.47 | $488,023.03 |
| Total interest | $289,595.47 | $238,023.03 |
| Payoff in | 30 yrs | 25 yrs, 6 mos |
That shows the massive power of compounding prepayments. Before you consider buying a home, you should calculate your monthly income cushion after your mortgage payment and try to pay some of that toward the principal. You’ll thank me later.
You can also submit smaller payments in between your regular monthly payments. If you have an extra $50 at the end of the week, you can apply it to your mortgage. By making larger monthly payments and extra payments, you will chip away at your loan’s principal over time.
We all daydream from time to time about how we’d spend our money if we won the lottery. Sure, yachts, long weekends in Ibiza, and hiring Counting Crows to play your birthday party all sound like a good time, but paying your mortgage may be a smarter financial decision.
Some mortgages do have prepayment penalties if you pay off large chunks — or the entire balance — at once. But you will be well aware if that’s the case because you must agree to them when you close on your home.
If you’re fortunate enough to come into a large sum of money, whether through lottery winnings, an inheritance, or e big raise at your job, you can make multiple prepayments on your mortgage or one big prepayment that covers the whole loan.
When you’re following a strategy of making smaller prepayments over a long period of time, you can reduce your mortgage’s term, which means paying the mortgage off faster.
Auto and Personal Loans
Cars are a symbol of freedom in the U.S. In fact, look up “freedom” in a dictionary, and you’ll see a picture of an attractive 20-something cruising down the Pacific Coast Highway in a convertible with their hair blowing in the breeze. Don’t fact-check me on that by the way, just go with it.
But the less glamorous side of buying a car is the debt that comes in the form of an auto loan. And you may want to pay off that debt well before your loan term ends.
Similar to mortgages, you can prepay personal loans, including auto loans, by either making extra payments from time to time, paying more than what’s due on your monthly payment, or by forking over a lump sum. These approaches can reduce your principal, saving you money and potentially reducing the life of your loan.
The one catch is that if you want to pay off the entire balance, you may find your auto or personal loan includes prepayment penalties. That means the lender could charge you around 2% (or more) of the outstanding balance to pay it all off.
On an auto loan that has $10,000 left, that might only be $200, which is probably far less than you’d pay in interest over the course of the loan. It is just something you should understand and calculate to see if it’s worth the fee.
Types of Prepayment Strategies
I’ve touched on some prepayment strategies so far, but let’s take a deeper dive and explore the specifics of different approaches to making prepayments:
- Biweekly payments: Most lenders direct borrowers to repay their loans via monthly payment. By making payments biweekly, you can take a big step toward paying off your debt.
- Increasing monthly payments: Perhaps the simplest method of prepayment is to pay more than what’s due each month. I outlined the pros of mortgage prepayments above. If you’re following this approach, you will add a certain amount to your payments each month or increase the amount you pay by a certain percentage. You’re the boss of your prepayments, so do what works for your budget.
- Lump-sum payments: Should you have extra cash but don’t want to fiddle with submitting payments that differ from what your lender stipulates you pay each month, consider making a lump-sum payment. A lump-sum payment doesn’t have to cover the entire outstanding loan balance, and you can submit lump-sum payments as often as you’d like.
Changes in Amortization Schedule
Though it has kind of an intimidating name, an amortization schedule can really help you manage your finances. When you make a prepayment, the amortization schedule for your loan may change.
Not only can a prepayment reduce your loan’s balance, but it can also reduce the total number of payments you’ll need to make to pay off your loan.
You can use online tools to calculate your amortization schedule and see how different monthly payment amounts can impact future amounts owed. Blockquote
Benefits and Potential Drawbacks of Prepayment
When making a financial decision, you should carefully weigh your options before acting. Here’s a practical outline of the pluses and minuses of making prepayments on credit cards, loans, and mortgages.
Benefits:
- Reducing Interest Costs: If you’ve taken out a mortgage to purchase your home, you know that you owe your lender more than just the value of the home. You have to pay interest on the loan. Interest costs can be significant, but prepayments can help lowering your principal and reducing your total interest costs.
- Accelerating Debt Freedom: The phrase “everything has a price” is almost always true in a capitalist society. But that saying is sometimes trumped by another trite expression — “you can’t put a price tag on freedom.” Prepayments can help shorten your road to becoming debt-free and give you priceless relief from creditors’ bills.
- Improving Financial Security: It’s hard to focus on being financially secure when you have a mountain of bills greeting you when you get home from work every day. But prepayments can help reduce and eliminate those bills, freeing up your cash for savings and investments. Having that money in your pocket can give you peace of mind and help you weather financial storms.
Potential Drawbacks:
- Prepayment Penalties: This is the fly in the ointment. Because lenders make a lot of money on your interest payments, some of them charge fees to make up for the income lost from prepayments. Prepayment penalties can apply to many types of loans, so review your loan agreements to learn the conditions of any prepayment fees your lender may charge.
- Impact on Cashflow: I’ve covered why prepayments might be the right move for your financial future, but be aware of how they can affect your cashflow today. Once you make a prepayment, that money is gone. So make sure you have enough cash on hand to cover your other expenses before prepaying a loan.
How to Decide if Prepayment is Right for You
Making prepayments on loans can be a great way to help you save money over the long run. But make sure paying off your loans early aligns with your financial goals. The right financial step for one person could cause another to stumble.
Read the Fine Print
Time to bust out those magnifying glasses and jump into the legalese.
Like eating vegetables, reading the fine print of a loan agreement isn’t most people’s idea of a good time. But doing so can help you avoid penalties and fees, which loan providers list in their disclosures.
Review Your Financial Situation
Most financial guidance isn’t one-size-fits-all. Sure, a lot of it can apply to many people and their circumstances, but you don’t want to spend your savings on prepaying your loan if it’ll cause you financial hardship down the line.
You can consult with a financial expert to get their perspective on your situation and learn about the tax implications of prepaying loans.
Calculate the costs of any prepayments you’re considering, including any penalties, and figure out how they fit in your overall financial picture. Make sure prepaying a loan won’t dry up your bank account.
Weigh the Pros and Cons
Review the prepayment benefits and drawbacks I laid out above, and consider how they relate to your financial position. Don’t forget to evaluate the opportunity costs of making prepayments to your creditors.
Once you’ve made a list of all the pros and cons, you’ll be better situated to determine if prepayments are the right choice for you.
Prepayment is a Good Strategy But Could Cost a Little Extra
Paying your loans early can put you on solid financial ground that prepares you for a bright future. All things considered, I say prepay … with a tiny asterisk. Those pesky penalties can put a damper on things.
Prepayment could cost you a little extra, but the benefits of being rid of a debt far outweigh that cost. So do the math and decide whether prepayments are the best move for you.
