July 3, 2014

Some schemes for paying off a mortgage early, such as biweeklies and bimonthlies, are offered by lenders while others are entirely within the control of the borrower. This article is about two schemes of the second type that keep popping up in my mailbox. Scheme 1 is all smoke and mirrors, and I doubt that any borrowers who understand exactly how it works will adopt it. Scheme 2 has much more substance, but borrowers who understand exactly how it works will probably also find a way to modify it to better match their unique needs and capacities.  

Scheme 1: Making a Large Payment Right After Closing 

In scheme 1, you take out a larger loan than you actually need, and make a large payment to principal immediately after the loan closes. This will shorten the term and reduce your interest payments.  

For example, assuming you need a 4% 30-year loan of  $280,000 to purchase your house, you borrow $300,000 and immediately after the closing you repay $20,000, reducing the balance to $280,000. Your loan will pay off in 317 months instead of 360, and you will pay $27,214 less interest than if you had borrowed $280,000 initially.   

How is that possible? The trick is that borrowing $300,000 instead of $280,000 increases your required monthly payment from $1337 to $1432, and the larger payment results in an early payoff. If you borrow $280,000 and make a payment of $1432 instead of the required $1337, you will pay off on the same schedule, and have the same reduction in interest payments, as borrowing $300,000 and immediately repaying $20,000. The difference is that when you borrow $300,000 the larger payment is obligatory and when you borrow $280,000 the extra payment is discretionary. 

Most borrowers prefer having the discretion, though there may be some who prefer being locked into the higher payment.  But the second group should  also recognize that their settlement costs will be larger. Costs that depend on the loan amount, including points and origination fees, title insurance and per diem interest will be calculated on $300,000 rather than $280,000. In addition, because of the way that loan servicing systems work, it is very likely that the borrower will pay a full month’s interest on $300,000, even if $20,000 is repaid the day after closing.

In sum, this scheme is for borrowers who are willing to pay larger settlement costs for the privilege of being locked into a higher monthly payment that will pay off the balance before term. 

Scheme 2: Matching Principal Payments With Extra Payments 

In scheme 2, which is much more ambitious than scheme 1, the  borrower makes an extra payment each month equal to that month’s principal payment. If this rule is followed religiously, the life of the mortgage is cut in half.   

There is an important proviso, however.  The extra payments required are larger than the principal payments that are customarily displayed as part of an amortization table, because such tables assume that there are no extra payments. For scheme 2 to work, the extra payment in each month must match the actual principal payment in that month, which amount has been affected by prior extra payments. This means that the required extra payment has to be recalculated every month, which can be a challenge -- unless you access the extra payment spreadsheet on my web site, which makes it a breeze.  

The attractive features of scheme 2 are the halving of mortgage life and the discipline it imposes on the borrower. A weakness is its rigidity, in the sense that every borrower is shoehorned into one repayment scheme. For many borrowers, funding the required extra payment will become increasingly difficult as time goes on. The required additional payment rises every month, without regard to the borrower’s financial capacity.  For example, in using this technique to pay off a 30-year 4% mortgage of $280,000 in 15 years, the required extra payment would rise from $403 in month 1 to $597 in month 60, to $889 in month 120, to $1325 in month 180.  

Some borrowers would manage better with a fixed extra payment. For example, an extra monthly payment of $734.36 would also pay off the 30-year 4% mortgage of $280,000 in 15 years. Further, if the borrower can’t manage the payment needed to pay off in15 years, a payoff in 20 years requires an extra payment of only $359.98. 

In sum, scheme 2 will work only for the relatively small number of borrowers who want to cut their mortgage life in half, and confidently expect the rising income that is required.  Other borrowers should set their own goals, which might be less ambitious than shortening the mortgage term by half, and their scheme should be geared to their own capacities for making payments. Calculators 2a and 2c on my web site were developed in order to allow each borrower to develop her own hand-tailored extra payment plan.