By JACK GUTTENTAG
The Mortgage Professor
Home owners 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. Next week, I look at various schemes that claim to make the task easier.
• 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 six 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 percent, 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.
• Is there a best time within the month to make an extra payment to principal?
Yes, the best time within the month to make an extra payment is the last day on which the lender will credit you for the current month, rather than deferring credit until the following month. If it is the 15th, for example, an extra payment made within the first 15 days of January will reduce your balance that month and the interest due in February. Payments made the 16th or later will not be credited until February, and the interest deduction will be deferred until March.
Some lenders will credit payments received anytime during the month, while others are much more restrictive. In most cases, extra payments sent in with the scheduled payment will be credited the same month, but it is a good idea to ask your lender what their rule is.
• Is there a best way to allocate extra payments when a borrower has two mortgages on the same property?
Yes, the general rule is to pay down the second mortgage first. Not only will the second have a higher rate, but second mortgages also can make life more complicated for borrowers looking to refinance or having payment difficulties.
The possible exception is a HELOC second, which might well carry a lower rate than the first mortgage, though it has high potential for future rate increases. The borrower who directs extra payments to a HELOC that has not yet reached the stage of mandatory repayment increases his credit line by the amount of the extra payment. This could be a desirable outcome for the borrower.
• Is there a best way to allocate extra payments when a borrower-investor has mortgages on several properties?
Yes, the general rule is that you save the most by paying down the mortgage with the highest interest rate first. One possible exception is where the mortgage that does not have the higher current rate is exposed to the most interest rate risk. For example, a borrower with a 4.5 percent fixed-rate mortgage and a 4 percent adjustable-rate mortgage, both in the early stages of their lives, might well elect to pay down the adjustable-rate mortgage.
Another possible exception would be where the lower-rate mortgage has a greater potential for a profitable refinance. For example, a 6 percent mortgage has a loan balance that is 89 percent of property value while a 5.75 percent mortgage is at 81 percent. If the extra payment directed to the lower-rate mortgage reduces the balance to 80 percent, no mortgage insurance would be required to refinance it.
A third possible exception is where the borrower-investor has so many mortgages that lenders refuse to finance any more acquisitions. In that situation, the borrower looking toward further expansion wants a complete payoff ASAP and will concentrate all extra payments to the mortgage with the smallest balance.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
