Prepayment is the process of paying down the loan early by increasing principal payments or by selling the home. On average, most homeowners in the United States move every five to seven years. You should know how to calculate your effective interest rate when you plan to prepay the loan (or sell the house) before maturity.

The EIR with prepayment is calculated in a similar manner to the EIR, except you must make an additional calculation for the balloon payment you will make when you pay off the loan.

1.  Calculate the payments on the total amount you will be repaying (the amount borrowed). Using your financial calculator, set N = your number of years, I = your interest rate, PV = the loan amount, and solve for your payment, or PMT.
2. Calculate the amount of money you actually received for your loan (the total loan less all costs). Again, assume that all costs for the home come out of the loan. This amount becomes your present value (with a minus sign).
3.  Calculate the balance that will remain after you prepay; in other words, calculate your balloon payment. This is the amount that you will need to pay off the remainder of the loan. To calculate the balloon payment, set N to the number of years or periods you will pay off the loan early. If you have a thirty-year loan, and you pay the loan off after twelve years, you want to know the present value of years 30 – 12, or eighteen years of payments. Set I to your interest rate, PMT to your monthly or annual payments, and solve for the present value. This balloon payment is the amount of principal that you will still owe after you prepay your loan. This amount becomes your future value.
4. Finally, set the number of years before prepayment as N (twelve years in the above example), the balloon payment or balance remaining as FV, the PMT as monthly or annual payments, the PV as negative the amount you received after paying points and fees, and solve for I to find your effective interest rate.

For example, assume from the previous problem that you want to know the effective interest rate should you pay off the loan after seven years. The first two steps are the same.

1. Your monthly mortgage payment will be $1,199. (PV=-200,000, I = 6%, N = 30*12, and solve for your PMT)
2. Two points and 1,500 in fees will be $5,500, resulting in a net to you amount of $194,500 ($200,000 – 5,500).
3. Your final payment at the end of year 7 will be $179,279. This is calculated at PMT = 1,199, N = (30 – 7) * 12, I = 6.0%, and solve for your present value.
4. Finally, put these figures into the equation, your PMT is $1,199, PV = - 194,500, N = 276, FV = 179,279 and solve for your Effective Interest Rate. You will get a rate of 6.51%.