What is accelerated depreciation?
Accelerated amortization is a process by which a mortgagor makes additional payments on the mortgage principal. With accelerated amortization, the borrower is allowed to add additional payments to their mortgage bill to pay off a mortgage before the loan settlement date.
The advantage of accelerated amortization is that it reduces the overall interest payments paid by the borrower over the life of the loan. And, of course, he pays off the debt sooner.
Accelerated depreciation should not be confused with accelerated depreciation, an accounting method for recognizing the decline in value of an item of property, plant and equipment over its useful life.
Key points to remember
- Accelerated amortization occurs when a borrower makes additional payments on the principal of their mortgage in excess of the amount declared due.
- There are a number of ways a borrower can make expedited payments, including increasing the amount of each payment or making more frequent payments.
- Borrowers use an accelerated amortization strategy to save money on interest and pay off their mortgage faster.
- Accelerated amortization has drawbacks: it can deprive the borrower of a tax deduction, and some lenders charge prepayment penalties.
How accelerated depreciation works
A mortgage loan is a type of amortized loan, which means that the borrower repays the loan in regular (usually monthly) installments over a period of time. These payments consist of both principal and interest.
Initially, most of the borrower’s payments will go towards paying the interest accrued on the loan, with a smaller portion of each payment going to pay off the principal. This ratio will reverse over time, and a larger portion of the borrower’s payment will go to repay the principal and a smaller portion will go to interest.
When a loan is taken out, the mortgage lender provides the borrower with an amortization schedule. This table shows how much of the borrower’s payment each month will be applied to the principal and how much interest until the loan is repaid.
With accelerated amortization, the borrower will make additional mortgage payments beyond what is shown in the amortization schedule. A borrower can speed up their loan amortization by increasing either the amount of each payment or the frequency of payments (bi-weekly mortgages are a common example). The additional accelerated payments serve directly to reduce the loan principal, which in turn reduces the outstanding balance and the amount owed on future interest payments.
Example of accelerated depreciation
Let’s say Amy has an initial mortgage loan of $ 200,000 at a fixed interest rate of 4.5% for 30 years. Composed of principal and interest, the monthly payment is $ 1,013.37. Increasing the payment by $ 100 per month will result in a loan repayment period of 25 years instead of the original 30 years, saving Amy five years in interest.
Benefits of accelerated depreciation
Adopting an accelerated amortization strategy has several advantages for borrowers.
The most obvious is that it shortens the term of the loan, which means you get rid of your debts sooner. Specifically, paying off a mortgage on an accelerated basis decreases the loan principal more quickly, which means that your equity (interest) in the home is also increasing faster. This increases your net worth and often strengthens your credit score.
In addition, accelerated amortization decreases the overall amount of additional interest incurred by the borrower. As a general rule, the longer a loan lasts, the more interest you pay. Although the interest rate itself does not change, by reducing the principal, you reduce the total interest charged on that principal, saving you money in the long run.
Limits of accelerated depreciation
There are also reasons why it might not make sense to prepay mortgage debt. The most important reason is that the interest on mortgage debt is tax deductible, according to the US tax code. Anyone who takes out a mortgage from December 15, 2017 to December 31, 2025 can deduct interest on a mortgage of up to $ 750,000, or $ 375,000 for married taxpayers filing separately. Although fewer US homeowners are choosing to claim the deduction than in the past, it does provide some homeowners with significant tax savings. By paying off a mortgage sooner, these homeowners could increase the income tax they owe.
In such a scenario, it may be wise for homeowners to use the funds they would have used for accelerated depreciation to invest in a retirement or college fund. Such a fund would generate a return while retaining the tax advantage of a mortgage interest deduction. However, very affluent buyers, who already have sufficient retirement funds and sufficient capital to make other investments, may want to pay off their mortgage sooner.
Some lenders include a prepayment penalty in their mortgage contracts. This is a clause that imposes a penalty on the borrower if they significantly repay or pay off their mortgage for a specified period (usually within the first five years of the mortgage issuance).
In the United States, homeowners typically take out a 30-year fixed-interest mortgage, secured by the property itself. The length of the loan and the fact that the interest rate is not variable mean that borrowers in the United States generally pay a higher interest rate on their loans than borrowers in other countries, such as Canada, where the interest rate on a mortgage is typically reset every five years.