Considering a fixed rate mortgage, how will increasing each monthly payment (i.e. paying extra) impact the loans effective rate (ER)? Make sure to support your answer with a brief explanation and an example to illustrate your explanation.
Answer
People often want to pay-off their mortgages earlier than the actual specified term of the loan. Firstly, many people would like to be debt free while others are interested in having the mortgage paid off before retirement. Financially speaking, paying a mortgage earlier that the required time to have the after-tax returns on the investment to be lower than the effective rate of the mortgage. Effective interest rate comprises of all forms of realized benefits in terms of tax through deductions of interest on the mortgage. When a mortgage has a stated fixed interest rate say 4.5%, the effective interest rate might be within mid threes. However, this often depends on the tax bracket on which the borrower falls as well as his ability to utilize the deduction loophole. There is a mortgage magic when a borrower decides to increase the principal payment by a certain amount for a given period of time. Nevertheless, this magic is not found in reducing the interest expense for each month.
The interest payments on a mortgage are determined by the outstanding loan balance at each given period. Therefore, if a person decides to pay an extra amount above the fixed payment, it means that there is a lower outstanding amount that can have outstanding implications on the effective interest rate of the mortgage. Furthermore, the interest payments can be greatly reduced when one decides to pay an extra amount above the fixed payment for the loan. For example, if a person borrows a mortgage of $100,000 at an interest rate of 4.5% and with a fixed loan term of 360 months, he can decide to go on with this plan and pay $506.69 per month. On the other hand, an individual can decide to pay an extra $100 on the principle monthly payment. With the initial plan of just $506.69, the borrower will have an accumulated interest expense of $82,406.71 compared to the plan of increasing the principal payment by $100 whereby the total interest expense is $56,028.95.

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