So many people I talk to want to know what's the best strategy for prepaying their mortgage. Ah, yes, the dream. We want to own our own homes but we don't want to be paying for them forever.

The answer I always give people is that if they want to pay off the mortgage sooner they should pay as much of the principal as soon as possible. The odd thing is people don't seem to grasp this. Maybe it's the result of advertising and marketing overplaying the appeal of "making one extra payment". It sounds so simple: Make an extra payment on your mortgage every year and you'll own your home that much faster.

The reality is that any mortgage prepayment at all shortens the overall life of a mortgage. Exactly how much the mortgage term gets reduced is determined by two things - the amount you prepay and when you make those extra principal payments. The only hard and fast rule is that earlier and larger payments have more shortening effect on your mortgage term than later and smaller payments.

The chart illustrates this fact. The lines represent outstanding principal on a standard 30-year fixed rate mortgage. I used a $100,000 loan amount, but the effect is exactly the same regardless of the loan amount. Each of the lines in the chart represent progressively more aggressive mortgage prepayment plans.

The blue line is a standard amortization. It shows the principal balance over the life of your loan as you make regular (no prepay) on-time payment amounts.

The lines to the left of the blue line depict what happens if you prepay your mortgage using progressively higher prepayment strategies. In each case I charted remaining principal given 1-4 extra mortgage payments each year. The green line, for instance, shows what happens to your mortgage if you increase each monthly mortgage payment by 8⅓%, effectively making one extra mortgage payment per year.

You'll notice three things about prepayment strategies from this illustration:

1. The prepayment effect isn't all that great in the first few years. Prepayment takes commitment, because the initial effects are hard to see. The reason for this is that your extra payment amount is a smaller percentage of the outstanding loan amount in the earlier years. But conversely...
2. The effect is much more dramatic in later years. As your extra payments add up, they increasingly represent a greater and greater percentage of the remaining loan balance. When this effect begins to take hold you really start to feel good about your commitment to prepaying your mortgage.
3. The third, and I think the most important realization, is that there is a diminishing returns process at work here. The amount of shortening from making two extra payments per year (the distance from the blue line to the green line) is greater than the benefit from making two payments (the distance from the green line to the yellow line) The more you prepay, the less effect each extra dollar has in terms of shortening the life of the mortgage

The trick, therefore, becomes understanding your investment alternatives and how they fit in with your long term plan for your financial health and well-being. In other words, given that extra dollar to invest, should you invest it in paying down your mortgage? Or should you put it in your IRA, for instance? The answer to that will vary depending on how you perceive risk and where you are on your own path to financial independence.