This is the second of a series on questions about mortgage repayment. The first article looked at mortgage repayment as a type of investment. This one is focused on payment mechanics.
Q: Will I save money if I make my regular monthly payment early?
A: No, paying early merely allows the firm servicing your loan to earn interest on your money until the first of the month when your payment is due. On a standard mortgage, the scheduled payment is due the first of the month, but there is a grace period of 10 to 15 days during which the payment can be made and will be credited as if it were paid on the first. If payment is received after the grace period, a late fee is imposed, but payments received before the due date are not rewarded for paying early.
An exception is the simple interest mortgage (SIM), on which interest accrues daily. On these mortgages, every day of delay in making the payment increases the interest cost, and the earlier you pay, the more interest you save.
Q: How do I know if my mortgage is simple interest?
A: Your note should say that interest accrues daily, but it might not. A sure sign is that the monthly payment on a SIM varies month to month, so if your monthly payment is always the same, you do not have a SIM.
Q: What is the best time of the month to make an extra payment?
A: It is the last day of the month for which the lender will apply the payment to the current balance. If you include the extra payment with your scheduled payment and pay within the grace period, the extra payment will be applied to the current balance. If you make the extra payment after the grace period, it might be applied to the current balance, or it might not be credited until the following month, depending on the systems/policies of the servicer. You should find out where the servicer’s cutoff is for crediting payments in the current month.
Q: If I make a large extra payment, will my future scheduled payments be lower?
A: On a fixed-rate mortgage, the scheduled payment is not affected by the extra payment. You merely pay down the balance faster. However, at your request and for a fee, some servicers will reduce the payment to the amount that will amortize over the remaining term. If you want to do this, arrange it beforehand.
On an adjustable rate mortgage, the scheduled payment remains the same until the next rate adjustment. At that point, the payment is recalculated based on the reduced balance, the new rate and the original term. So unless it is offset by a rate increase, the payment will drop.
Q: What is the difference between an extra payment and an advance payment?
A: An extra payment reduces the loan balance, while an advance payment is the scheduled payment made before the due date. It is an interest-free loan to the servicing agent for the period until the payment comes due. Advance payments serve no purpose for borrower s except for the possible peace of mind that stems from knowing that they are ahead of the game.
Q: How does the servicer distinguish an advance payment from an extra payment?
A: The borrower’s actions usually indicate the intention. If the borrower remits a check that is $100 larger than the scheduled payment, for example, the servicer will interpret the $100 as an extra payment and credit it accordingly.
The one ambiguous situation would be where the borrower pays an amount that is an exact multiple of the scheduled payment, which could be intended as several scheduled payments, or as one scheduled payment with a substantial extra payment. It is up to borrowers to make their intentions clear.
Q: Aren’t advance payments necessary if you plan to be out of touch for a long period?
A: No. I spent a year traveling and never made any advance payments on my mortgage. Before I left, I gave my mortgage lender 12 checks dated on the first day of 12 consecutive months. These were not advance payments because the checks would not clear before those dates.
Q: How do I know that the lender has credited my account promptly for my extra payment?
A: You should be able to tell from monthly statements received from the lender that show all transactions during the month by date. Such statements should be mandatory, but they aren’t. Many borrowers receive only an end-of-year statement. The best approach for them is to keep track of their account using Excel spreadsheets I developed for this purpose, then match the results against the end-of-year statement received from the lender. The spreadsheets, on my website, are Extra Payments on Monthly Payment Fixed-Rate Mortgages, and Extra Payments on Adjustable Rate Mortgages.
Q: Can I pay off an adjustable-rate mortgage early?
It is difficult but doable if you know how. The reason it is difficult is that the extra principal payments designed to shorten the term reduce the scheduled monthly payment at each rate adjustment, because the new payment is calculated to pay off over the original term.
To offset the decline in the scheduled payment, the borrower must increase the extra payment at every rate adjustment date. This is a pain, but I now have a calculator that eases the pain substantially. On my website, this is Extra Payments Required to Pay Off By a Certain Period. The procedure is described in Using a Calculator to Prepay an ARM.
—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.c