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Prepayment vs. Investment Analysis - Interest.com

In managing one's own finances, as well as those of a business, there are numerous decision situations where applications of "Time Value of Money" (TVM) concepts and methods help one assess the financial consequences of alternative courses of action. One such situation is the decision to prepay part or all of one's mortgage or loan balance by making extra periodic principal payments. As one makes extra principal payments, the loan balance is reduced faster. This means you pay less interest over the life of the loan and the loan will be repaid earlier (i.e. fewer payments). For example, a person might decide to pay $50.00 per month extra (i.e. if their mortgage payment was $900 per month, they might pay $950 each month, $50 extra) on a mortgage loan. The extra payment of $50 would be applied each month to reduce the principal balance. However, there are important factors to consider before making this decision. For example, if the mortgage loan is on the person's primary residence, the interest on the loan may be tax deductible. This reduces the net, after-tax cost of the loan.

To consider the financial consequences of this decision, visit the website http://www.interest.com/hugh/calc which offers various web calculators free, including a prepayment versus investment scenario analysis. Before using this website, you will need to amortize the loan you will use as input data for the analysis.

Suppose you purchase a home for $150,000 and obtain a 90% mortgage loan, 30-year maturity, at a fixed annual interest rate of 8.0%, with deferred monthly payments. What is the monthly payment for principal and interest (P&I) on this loan?

The loan amount is $150,000 x 0.90 = $135,000 The calculator keystrokes follow. PV = - $135,000; N = 360 (30yrs x 12 per year); I = 8.0%/12 = 0.6667; FV = 0 (the loan will be paid off at maturity); SOLVE for PMT = $990.62 Note: If you enter the interest rate at 0.6667% per month you get the payment above. If you carry full precision on your calculator, the PMT = $990.62.

The data you will need for the prepayment scenario include the following.

*The Investment rate return is your opportunity cost estimate. It is the annual rate you think you can earn on the $50 extra principal payment if you did not make extra principal payments on your mortgage but instead, invested it.

Now visit the website http://www.interest.com/hugh/calc, and select Prepayment vs. Investment.

  1. After 12 months of making extra payments, what will be the loan balance?

  2. After 12 months of making the regular payment and investing the $50, what will be the loan balance?

  3. Under the regular payment and investing option, excluding the tax due on the interest earned, what is the investment balance after 12 months?

  4. Compare the scenarios of investment versus prepayment by examining the 60th payment, which occurs at the end of the fifth year. What is the difference between the (a) interest portion of that payment, (b) tax deduction for interest, and (c) principal balance? Finally, how much is in the investment account?

  5. (a) How long does it take to repay the entire loan under the prepayment option? (b) What is the total interest paid over the life of the loan?

  6. Compare the total interest paid under each scenario? How much less in interest do you pay under the prepayment option?

  7. If you make an extra $50.00 principal payment per month, what are the opportunity cost considerations?

  8. What are the relevant cash flows to consider in this decision? For example, do you consider the tax implications and if so, then how?

  9. Do you go out to lunch too often? Use Hugh's Lunch Savings Calculator to see how much money you can save by not going out to lunch. Suppose you usually spend $6.00 a day when you go out to lunch, when bringing your lunch to school/work would only cost you about $2.00 a day. Since there are approximately 250 weekdays in a year, enter that value for the days eaten per year. How much money would you save after 15 years if you could earn a 10% yield on the money you save?

  10. Suppose your investment account earns an average annual return of 9%, and the average rate of inflation is 3%. Using Hugh's "What's a Million" calculator, how long would it take to have a million dollars, if you started with an initial investment of $20,000and made monthly $150 contributions (assume that your deposits are inflated at the average rate of inflation)?
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