Definition of accelerated depreciation


What is accelerated depreciation?

Accelerated amortization is a process by which a mortgagor makes additional payments toward the principal of the mortgage. With accelerated amortization, the loan borrower can add additional payments to the mortgage bill to pay off a mortgage before the loan payment date. The benefit of accelerated amortization is that it reduces the total interest payments paid by the borrower over the life of the loan. And, of course, retire the debt sooner.

Accelerated depreciation should not be confused with accelerated depreciation, which is an accounting method for recognizing the decrease in the value of property or equipment over its useful life.

Key takeaways

  • Accelerated amortization is when a borrower makes additional payments toward their mortgage principal beyond the stated amount owed.
  • There are different ways a borrower can make accelerated payments, including increasing the size of each payment or making more frequent payments.
  • Borrowers use an accelerated repayment strategy to save money on interest and pay off their mortgage faster.
  • Accelerated repayment has drawbacks: It can deprive the borrower of a tax deduction, and some lenders charge prepayment penalties.

How Accelerated Amortization Works

A home mortgage is a type of amortized loan, which means that the borrower repays the loan in regular installments (usually monthly) over a period of time. These payments consist of both principal and interest.

Initially, the majority of the borrower’s payments will go toward paying the accrued interest on the loan, and a smaller portion of each payment will go toward paying the principal. Over time, this ratio will reverse, with a larger portion of the borrower’s payment going toward principal and less toward interest.

When a loan is obtained, the mortgage lender provides the borrower with a repayment schedule. This table shows how much of the borrower’s payment each month will be applied to principal and how much to interest until the loan is paid off.

With accelerated amortization, the borrower will make additional mortgage payments beyond what is stated in the amortization schedule. A borrower can speed up the repayment of his loan by increasing the amount of each payment or increasing the frequency of payments (biweekly mortgages are a common example). Accelerated extra payments go directly to reducing the principal of the loan, which in turn reduces the outstanding balance and the amount owed on future interest payments.

Accelerated amortization example

Let’s say Amy has a mortgage with an original loan of $ 200,000 at a fixed interest rate of 4.5% for 30 years. Composed of principal and interest, the monthly payment amounts to $ 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 of interest.

Advantages of accelerated amortization

Adopting an accelerated repayment strategy has several advantages for borrowers.

The most obvious is that it shortens the life of the loan, which means you’ll get out of debt sooner. More specifically, paying off a mortgage quickly lowers your loan principal faster, which means your home equity (equity interest) increases faster, too. This increases your net worth and often strengthens your credit score.

Also, accelerated amortization lowers the total amount of additional interest incurred by the borrower. Generally, the longer a loan lasts, the more interest it pays. Although the interest rate itself does not change, reducing the principal reduces the total interest charged on that principal, saving money in the long run.

Limitations of accelerated depreciation

There are reasons why it might not make sense to pay off your mortgage debt early. The most important reason is that the interest on the mortgage debt is tax deductible, according to the US tax code. Anyone who obtains a mortgage between December 15, 2017 and December 31, 2025 can deduct the interest of a mortgage of up to $ 750,000, or $ 375,000 for married taxpayers filing a separate return. While fewer US homeowners choose to claim the deduction than in the past, for some homeowners it provides significant tax savings. By paying a mortgage early, these homeowners could increase the income tax they owe.

In such a scenario, it may make sense for owners to use the funds they would have used for accelerated depreciation to invest in a college or retirement fund. Such a fund would earn a return while maintaining the tax advantage of a mortgage interest deduction. However, very wealthy buyers who already have enough retirement funds and enough capital to make other investments may want to pay off their mortgages early.

Some lenders include a prepayment penalty in their mortgage contracts. This is a clause that assesses a penalty for the borrower if he significantly pays or cancels his mortgage during a specified time (usually within the first five years of the mortgage origination).

Special Considerations

Homeowners in the United States typically purchase a 30-year fixed rate mortgage, secured by the property itself. The length of the loan, and the fact that the interest rate is not variable, means 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 rate Interest on a mortgage is normally restarted every five years.

www.investopedia.com

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Mark Holland

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