Mortgage Blog

Some schemes for paying off a mortgage early, such as biweeklies and bimonthlies, are offered by lenders while others are entirely within the control of the borrower. This article is about two schemes of the second type that keep popping up in my mailbox. Scheme 1 is all smoke and mirrors, and I doubt that any borrowers who understand exactly how it works will adopt it. Scheme 2 has much more substance, but borrowers who understand exactly how it works will probably also find a way to modify it to better match their unique needs and capacities.

Scheme 1: Making a Large Payment Right After Closing

In scheme 1, you take out a larger loan than you actually need, and make a large payment to principal immediately after the loan closes. This will shorten the term and reduce your interest payments.

For example, assuming you need a 4% 30-year loan of $280,000 to purchase your house, you borrow $300,000 and immediately after the closing you repay $20,000, reducing the balance to $280,000. Your loan will pay off in 317 months instead of 360, and you will pay $27,214 less interest than if you had borrowed $280,000 initially.

"My wife and I are looking to purchase a $450,000 home, and I am wondering whether I should apply for the mortgage we will need as an individual, or jointly with my wife? I make $84,000 a year and have a credit score of about 800. She makes $48,000 and has a credit score of about 680."

Congratulations on considering this question before you start house shopping. The extra time could come in handy, as I'll explain shortly.

However, you haven't given me enough information to answer your question. In addition to your incomes and credit scores, I need to know your financial assets and debt payments, held individually and jointly. Also, give me your best guess as to how long you will have the new house.

"I have about $25,000 of financial assets in my name and no debts, she has $32,000 and no debts. Figure we will be here for 7 years."

For over 40 years, the centerpiece mortgage disclosure mandated by Truth in Lending (TIL) has been the Annual Percentage Rate or APR. Recently, administration of TIL has shifted from the Federal Reserve to the new Consumer Financial Protection Bureau (CFPB), which has developed a new disclosure form called the Loan Estimate. Beginning August 2015 this form will replace both the TIL and a sister disclosure called the Good Faith Estimate. While the Loan Estimate eliminates some junk from the two disclosures it replaces, it carries over the APR from the TIL without significant change. The APR thus retains its role as the centerpiece of mandatory disclosures.

The appeal of the APR is that it is a single measure of credit cost that includes both the interest rate and upfront loan fees charged by the lender. If loan fees are zero, the APR equals the interest rate. The higher are the loan fees, the larger is the APR relative to the rate.

The purpose of the APR is to provide a single measure that borrowers can use to compare loans of different types and features, and loans offered by different loan providers. Unfortunately, however, the APR has so many limitations that the list of borrowers who cannot use it effectively is much longer than the list of those who can.

A standard fully-amortizing mortgage pays off the balance over the term. With a 30-year term, this requires 360 monthly payments, while a 15-year term requires 180 payments. Many lenders, however, offer special loan repayment programs that promise to pay off the balance before term, without imposing much of an added burden on the borrower. This article looks at the most common of these schemes, as well as an alternative that borrowers can adopt on their own.

Bimonthly Payment Plans

On a bimonthly payment plan, the borrower's monthly payment in split into two pieces of equal size, one due on the 15th of the month and the other on the first. While the borrower makes 24 payments a year instead of 12, they add to the same total. However, the lender credits the half payment on the 15th to the balance on the 15th, which reduces the interest due on the first.

While the reduction in interest shortens the period to payoff, the impact is small. On 30-year mortgages with rates of 6% or less, payoff occurs after 719 half payments, shaving just one-half of a month off the term. On a 7% mortgage, payoff occurs after 718 half payments, accelerating payoff by one month.

There isn't anything wrong with the bimonthly mortgage, provided that paying twice a month is convenient and you don't give up anything of value to get it. Readers have reported to me that loan officers touting the bimonthly have told them that the term would be reduced to 23 or 24 years, which is nonsense.

Homeowners with a mortgage usually want to reduce their interest cost by paying down the loan balance as fast as possible. This article is about what borrowers can and cannot do on their own.

Is There Any Benefit In Making Scheduled Payments Before the Due Date? No. One of the many readers who have asked me this question told me that she was in the habit of making payments 6 months early! She was crestfallen to learn that this practice did not reduce her interest cost at all.

On a standard mortgage, interest accrues monthly, and is calculated by multiplying one-twelfth of the annual interest rate times the loan balance at the end of the preceding month. For example, if the loan balance is $100,000 and the interest rate is 6%, the interest due is .06/12 x 100,000, or $500. The borrower owes $500 regardless of when the payment is made or how many days there are in the month. If the payment is late by more than the 10 or 15 day "grace period", there is an additional late fee. But there is no rebate for paying early.

Simple interest mortgages, on which interest accrues daily, are an exception. On these mortgages, every day of delay in making the payment increases the interest cost, and paying early does reduce the borrower's interest bill. Simple interest mortgages used to be fairly common, but I am not aware of any being offered today.

Do Extra Payments Save More Interest When Made In Some Months? No, the only valid rule is that the sooner you make the payment, the more interest you will save.

An idea that keeps popping up in my mailbox is that the best month in which to make extra payments to principal is January. It is certainly true that a January payment saves more interest than one made in the succeeding February, but it saves less than one made the preceding December.