One of my clients recently asked me if he should make monthly prepayments on a mortgage for an apartment building he owns. He bought this property a few years ago and has worked hard to turn it into a profitable investment. As it looks right now, he estimates he’ll have monthly positive cashflow of $2,850.
He was considering his options for this monthly cashflow and wanted to know my thoughts on mortgage prepayment. He shared that his interest rate was 5.375% and sent me his loan amortization schedule. At first, I told him he could probably get a better return on investment investing the cashflow into other assets. If he got a return on this monthly cashflow above 5.375%, he would be better off. (This isn’t factoring in the tax savings on the mortgage interest. I do realize his actual out of pocket cost for the mortgage interest is less than 5.375% because of the tax deduction.)
For some reason, I spent some time studying this amortization schedule and have come to a different conclusion. It’s crazy, but I’ve owned real estate for many years as an investor and have never really studied an amortization schedule. I was also a CPA for many years before I got into real estate and still never really examined amortization schedules. I always focused on the mortgage interest rate and made all decisions around this one figure. If the mortgage interest rate was higher, it was a good idea to make prepayments. If the mortgage rate was lower, it was better to make the minimum payment and use the funds in other investment opportunities.
Well, I’m starting to rethink this after looking at this amortization schedule. Here’s an ugly screenshot from this amortization schedule:
The total monthly mortgage payment 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 mortgage payment 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.
Not too bad, if you ask me.
Here’s what caught my attention about the amortization schedule. If this investor did make the extra principal payment for January 2015 of $1,211.53, he would 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 in January.
Is this correct?
If so, I’ve been missing out on an amazing investment opportunity. Maybe you have too?
Who wouldn’t want to invest $1,211.53 one month for a guaranteed $2,855.96 in the very next month? 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% 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)
I’m writing this at 5:45 am and have been up working for awhile. I might be delusional. 🙂
Is it possible to make 129% guaranteed prepaying a mortgage with a 5.375% rate?
What do you think? Is this thinking correct, or am I missing something?