Using a Calculator to Prepay an Adjustable Rate Mortgage

August 18, 2000 Trying to pay off an ARM early is tricky. Systematically adding a fixed amount to the payment every month doesn't work because when the interest rate changes, the mortgage payment is recalculated so that the loan will pay off in the period remaining of the original term. This means that the extra principal payments that have been made have the effect of reducing the monthly payment at the rate adjustment, rather than the term. This problem is described in Can I Pay Off ARM Early? The only way to shorten the term on an ARM is to increase the extra payment at every rate adjustment date so as to offset the decline in the scheduled payment resulting from prior prepayments.  My calculator Extra Payments Required to Pay Off By a Certain Period can help you by showing the new extra payment you must make after every rate adjustment. Here is an example using a 30-year 3/3 ARM, meaning that the initial rate runs for 3 years, and the rate is adjusted every 3 years thereafter. This loan was originally for $150,000 at 7%, rising to 7.25% at the first rate adjustment when the balance is $145,090. The borrower decides after 3 years that she wants to pay off the loan in another 15 years rather than 27 years as scheduled. In the calculator she enters the current balance of $145,090, the new 7.25% rate, the period remaining of the original term of 324, the desired payoff period of 180, and the first extra payment to begin in month 1. The calculator shows a new scheduled payment of $1021.72 and an extra payment required to pay off in 180 months of $302.76. This payment holds for the ensuing 3 years, when the rate and payment are adjusted again. The rate at the end of year 6 falls to 7.125% and the new balance is $127,139. These are entered in the calculator along with the new period remaining of the original term of 288 and the new desired payoff period of 144. The calculator now shows a new scheduled payment of $922.60 and an extra payment required to pay off in another 144 months of $393.36. At each rate adjustment, unless there is a massive increase in the rate, the scheduled payment will decline because of the earlier extra payments, and the new required extra payment will increase. If the borrower sticks to this procedure, the loan will pay off in the desired 180 month period. Copyright Jack Guttentag 2002

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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