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April 9, 1999
" A mortgage broker
told me that you could pay off a loan faster by paying, in advance,
designated- specific-future principal payments. He said that this was an
even more financially beneficial method than making bi-weekly payments or
by making an extra mortgage payment a year. Any comments?"
Ever since I
began inviting readers of my column to leave questions on my web site, I
have been amazed at the frequency with which I encounter the following
bubba meiser (myth): There is some way to make extra payments that pays
off a loan quicker than other ways. Often the magic has to do with
something one writes on the check telling the lender how the payment is to
be used. It is always someone else who has told my reader about this
magical way of paying off the loan.
Sorry, but it just isn't true. Any
additional payment above the regular payment (but less than the amount of
the payment) repays an equivalent amount of principal, no matter what you
write on the check. For example, if the regular monthly payment is $600 of
which $500 is interest, the other $100 is used to reduce the loan balance.
If you make a payment of $650, the loan balance will decline by $150.
Since the interest has already been paid, the additional $50 is used to
reduce the balance by the same amount.
999 times out of 1,000 the
lender's computerized servicing system does this automatically. Of course,
if your lender's account records are maintained by a guy with a quill pen
and a green eye shade who sits on a stool, you may have to watch what he
does.
If you pay an additional amount
that is a multiple of the regular payment, however, it is not
automatically applied to principal reduction because the borrower may
intend it as an early payment of future installments. If your
monthly payment for April is $600, for example, and you send in a
check for $1200, the lender does not know unless you tell him whether you
wish to reduce the principal by another $600, or to make your May payment
early. If you intend it as a reduction of principal but don't inform
the lender, the lender may interpret it as the May payment sent early, in
which case the lender gets the interest on the $600 during April instead
of you.
There is no magic involved in
paying off early. The larger the extra payment, and the sooner it is made,
the faster you pay off the balance. An extra payment of $50 a month will
result in faster payoff than a single payment of $600 at the end of the
year, but a single payment of $600 at the beginning of the year will yield
a faster pay off than both.
Caveat: With
amortized mortgages, the benefit of early prepayment has to do with the
month in which the payment is received by the lender, but it is not
affected by when it is received within the month. Thus, $100
received by the lender on May 1 or on May 30 both reduce the loan balance
on May 31, on which the interest payment due June 1 is calculated, by
$100.
The biweekly mortgage, where the
borrower pays half the monthly payment every two weeks, provides the
equivalent of one extra payment at the end of every year. If the payment
is $600, for example, the borrower pays $300 every 2 weeks. The payments
go into a special account from which $600 is withdrawn at the end of every
month for 11 months. But by the 12th month, enough has been
accumulated in the account to pay $1200. The biweekly thus pays off at the
same time as a standard mortgage on which the borrower makes a double
payment at the end of every year.
Copyright Jack Guttentag
2002
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