Vail Daily column: Principal reduction payments offer benefits
There are many ways to skin the proverbial cat. As this applies to most anything in life, it certainly applies to one’s mortgage as well. Even after 13 years of being entrenched in this business, I still see and learn new things and new ways of structuring mortgage financing. I think this may be particularly true in the Vail Valley. Here, there are a wide range of property types, property values and each individual borrower can be vastly different from the last.
One such example that I have run across lately is when borrowers take on a mortgage with a longer amortization term with the intentions of making prepayments to the principal balance on their own accord. That statement is better understood by looking at analyzing specific numbers.
For starters, a $350,000 loan amount with an interest rate of 4.25 percent on a 30-year fixed rate mortgage will have a monthly mortgage payment of $1,721.79. Interest owed over the life of the loan will be $269,884, assuming no additional principal reduction payments are made on the loan.
A reduction of the loan term to 25 years (i.e., a 25-year fixed rate mortgage) would have the same interest rate of 4.25 percent. Assuming the same $350,000 loan amount, total interest owed over the 25 term would be reduced to $218,825, and the monthly mortgage payment would increase to $1,896.08. So the monthly mortgage payment increases by $174.29, but the interest owed on the loan decreases by $51,059. The term is obviously reduced by five years as well.
That’s one way to reduce the term and interest of a mortgage. However, once you sign on the dotted line with the 25-year loan, you are locked in to that payment and schedule. Some borrowers have the desire to pay off the mortgage in full in less than 30 years, but they may have a difficult time committing to the increased monthly mortgage payment every month.
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By committing to the 30-year fixed-rate loan, the borrower is only required to pay the $1,721.79 per month (plus taxes and insurance and any applicable HOA dues). The borrower can then elect to make additional principal reduction payments on their own accord to reduce the interest on the loan and shorten the term. By simply making one additional monthly payment of $1,721 per year, the term is reduced to 26 years and the interest owed decreases by $42,180. One hundred dollars additional paid each month to the principal balance would reduce the term by three years and the interest by $32,125.
If the borrower is in an employment position where they receive large commission or bonus type earnings and they were to allocate, say, $5,000 per year to the principal balance of the mortgage, then the savings are staggering. Interest on the loan is reduced by nearly $100,000 and the term is cut to just over 20 years.
By financing the debt with a 30-year fixed-rate mortgage, a borrower is committed to the lesser monthly payment. But assuming the loan does not have a prepayment penalty associated with it, the borrower is free to make principal reduction payments to the loan at any point. Doing so can have a significant impact on the interest owed over the life of that loan and on the time in which it takes to pay the loan off. The key being that the borrower has the autonomy to make the principal reduction payments when it is best suited for them financially as opposed to being tied to the higher monthly payments.
There are many ways to structure loans in the current environment, and it is important that borrowers fully understand the options available to them with every scenario. Doing so requires the guidance of a seasoned and professional loan officer.
William A. DesPortes, of Central Rockies Mortgage Corp., can be reached at 970-845-7000, ext. 103, and firstname.lastname@example.org.