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4 April 2005
"I am looking for a loan on which, whenever I
make an extra principal payment, my monthly payment immediately declines. Is
there such a thing?"
The only mortgage that works that way is one
on which the payment is interest-only. Not all interest-only mortgages work that
way, however.
Impact of Extra
Payments on Monthly Payment: Conventional FRMs
With a fixed-rate mortgage of the standard
type, extra payments shorten the payoff period but do not affect the monthly
payment. For example, if you borrow $100,000 for 30 years at 6%, your
fully-amortizing payment is $599.56. Pay this amount every month, and you are
out of debt after making 360 payments. If you make an extra payment of $90,000
in month 2, your payment in month 3 and all subsequent months remains $599.56
until month 20, when the loan balance hits zero. Until then, you receive no
payment relief.
Impact of Extra
Payments on Monthly Payment: Conventional ARMs
With an adjustable-rate mortgage (ARM) on
which the borrower is making the fully amortizing payment, extra payments do
change the monthly payment, but not until the next rate adjustment. At that
point, the payment is recalculated and the new payment will reflect all prior
reductions in the balance.
Assume the $100,000 6% loan is a one-year
ARM, and that an extra payment of $90,000 is made in month 2. The payment would
remain at $599.56 through month 12, but (assuming the rate stayed at 6%) the
payment would drop to $13.81in month 13.
On ARMs with longer initial rate periods, the
drop in payment following an extra payment would be further delayed. On the
popular 5-year ARM, for example, the payment wouldn�t drop until month 61.
Impact of Extra
Payments on Monthly Payment: Loans With an Interest-Only Option
If a loan is interest-only, the payment
should decline in the month following an extra payment, whether the loan is
fixed-rate or adjustable-rate. The interest only payment on the $100,000 loan at
6% is $500. Following the payment of $90,000 in month 2, the interest-only
payment should drop to $50 in month 3.
From the mail I have received on this topic,
however, I get the distinct impression that not all lenders have their servicing
systems geared to do this properly. This is not surprising, given the haste with
which many lenders have incorporated interest-only into their program offerings.
Even if the system calculated the new interest-only payment correctly, they need
to communicate the new interest-only payment to the borrower. I have not done a
comprehensive survey, but I do know that some lenders are not doing this.
In most cases, lenders who do not change the
payment immediately will change it on the anniversary month, as specified in the
note. Until that date, the payment will remain unchanged, but since the interest
due is lower, a part of the payment will be credited to principal.
If the loan in my example is of this type,
the interest due in month 3 will drop to $50, but the borrower will continue to
pay $500 until month 13, which is the anniversary month. $450 will be applied to
principal in month 3. In each subsequent month 4-12, the interest portion will
drop a little and the principal portion will rise, until month 13, when the
borrower will once again be able to pay interest only.
There are some interest-only loans on which
the interest-only payment in month one continues until the end of the
interest-only period � 5 or 10 years.
If it is an ARM, the payment will adjust when
the rate adjusts, but if it is fixed-rate, the payment won�t change for 5 or 10
years.
If you are contemplating an interest-only
loan and find immediate payment adjustments in response to extra payments a
highly desirable feature, ask about it. Don�t expect the subject to be
volunteered by the loan officer or mortgage broker. They are not involved in
loan servicing and the chances are that they don�t know the answer and will have
to ask. Make sure they do.
Copyright Jack Guttentag 2005
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