Do Some Prepayment Methods Work Faster?

April 9, 1999, Reviewed February 4, 2010, May 5, 2011

" 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 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, provided it is received within the grace period. Thus, $100 received by the lender on May 1 or on May 10 both reduce the loan balance on May 1, on which the interest payment due June 1 is calculated, by $100. Payments received after the grace period may be credited to the May 1 balance, or to the June 1 balance, depending on the practice of the servicer.

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. See Bimonthly and Biweekly Mortgage Payment Plans.

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