Partial Prepayments

Partial Prepayments (or Paying Off Early)

Making a payment larger than the fully amortizing payment as a way of retiring the loan before term.

Making Extra Payments as an Investment: Suppose you add $100 to the scheduled mortgage payment. This makes the loan balance at the end of the month $100 less than it would have been without the extra payment. In the months that follow, you save the interest on that $100. Since the interest payment that you would have made is determined by the interest rate on your mortgage, the yield on your $100 investment is equal to that rate.

Absent any prepayment penalty, principal repayment yields a return equal to the interest rate on the loan. A prepayment penalty would reduce that yield.

Factoring Taxes into the Equation: Many borrowers want to reduce the yield on mortgage repayment by the amount of the lost tax saving. If the borrower is in the 36% tax bracket, for example, his or her after-tax yield on an 8% mortgage is (1 - .36) x 8, or 5.12%.

If the yield on mortgage repayment is being compared with the yield on other taxable investments, however, it doesn't matter whether yield is measured before tax or after tax. If mortgage repayment is compared with a 6% taxable bond, for example, the beforetax comparison is 8% versus 6%, while the after-tax comparison is 5.12% versus 3.84%. The conclusion, that mortgage repayment earns the higher return, remains the same.

On the other hand, if the alternative investment is tax-exempt, you should compare only after-tax yields.

Partial Prepayments Versus Other Investments:  To  determine whether paying more principal is a good investment, the yield should be compared with the yield on alternative investments, with allowance for differences in risk. An investment in mortgage repayment carries zero risk.

Mortgage repayment will always carry a higher return than other riskless investments—insured certificates of deposit and U.S. government securities. However, investments that shelter income, such as contributions to a 401(k) plan, will usually generate a higher after-tax return than mortgage repayment. In addition, a diversified portfolio of common stock may yield 12-15% over a long time horizon, provided the borrower is prepared for the risk of short-term fluctuations in portfolio value.

Seniors Versus Juniors: Investing in mortgage repayment is generally smarter for a senior than for anyone else. Many seniors no longer have income to shelter; even those that do have a lower after-tax return because the tax deferment period is short. Furthermore, where a diversified portfolio of common stock is a prudent risk for people in their 30s or 40s, it is less prudent for those in their 70s or older. A single stock market tumble could crack their nest egg. For this reason, mortgage repayment is a preferred investment for many older investors.

This does not necessarily mean, however, that they should repay the entire mortgage balance at one fell swoop, as explained below. The partial prepayment decision and the repayment in full decision are very different.

Partial Prepayment Versus Repayment in Full: Whether to allocate excess cash flow to mortgage repayment is a relatively easy decision because borrowers get to change it every month if they want. They prepay if the mortgage rate is higher than the rate that can be earned this month on newly acquired financial assets. Next month, the investment rate could be higher and the decision different.

Whether to repay the entire mortgage balance by liquidating financial assets, in contrast, is a single, irrevocable decision. Either
the assets are liquidated to pay off the mortgage or they aren't.

While the principle, that the decision should be based on comparison of the mortgage rate and the investment rate, is the same, borrowers can't adjust to future changes in the investment rate. They have to look ahead and anticipate what these changes might be as well as how long they will be around.

To help deal with this problem, I developed a spreadsheet that allows borrowers to enter any scenario for future interest rates and compare their wealth in every future month in the two cases: where they liquidate their assets to repay the mortgage at the outset and where they retain both the mortgage and the assets. The spreadsheet is available on my Web site.

For example, assume the mortgage rate is 6% while the current investment rate is 2%, but the  borrower assumes that in two years it will jump from 2% to 7%, and stay there. The spreadsheet shows that for the first 67 months, the borrower's wealth would be greater in the case where he or she repaid the mortgage. After 67 months, this person's wealth is greater in the case where he or she didn't. The borrower then must decide whether he or she is likely to be around for more than 67 months.

In general, the sooner interest rates increase, the larger the increase when it happens, and the longer the borrower expects to live, the weaker the case for liquidating assets to pay off the mortgage. Seniors having to make this decision may find it instructive to play with the spreadsheet.

Mechanics of Paying Early:To repay early, just increase the amount of your monthly check. With the exception noted below, you don't have to tell the lender to apply the extra payment to principal. There isn't anything else the lender can do with it except steal it, and if he wants to steal it, nothing you write on the check will stop him.

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 sitting on a stool, you may have to watch what he does.

But don't make an extra payment equal to the exact amount of your regular payment without telling the lender what you want
done with it. If your monthly payment for April is $600, for example, and you send in a check for $1,200, 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.

Excepting simple interest mortgages, the benefit of early prepayment is not affected by when it is received within the month. Thus, $100 received by the lender on May 1 or on May 20 both reduce the loan balance on May 31, on which the interest payment due June 1 is calculated, by $100. On simple interest mortgages, however, extra payments reduce the balance on the day they are received and posted.

Effect of Early Payment on Monthly Payments: Extra payments to principal affect different types of mortgage differently.

FRMs: On an FRM, extra payments shorten the period to final payoff but do not affect the monthly installment payment. This is sometimes a source of frustration to borrowers who come into a sizeable amount of money that they would like to use to reduce their installment payment burden. They can't do it except by refinancing the reduced loan balance.

On balloon mortgages, the monthly installment payment is not affected either. However, the balance that must be rolled over at the end of the five- or seven-year rollover period is lower than it would be otherwise. And this means that the new installment payment is lower than it would be otherwise.

ARMs: Where it is difficult to reduce the monthly installment payment on an FRM, it is difficult to shorten the payoff period of an
ARM. The reason is that every time the mortgage payment is recalculated to reflect changes that have occurred in the interest rate, the calculation assumes that the loan will pay off in the period remaining of the original term.

For example, if the interest rate on a 30-year ARM is adjusted after five years, the payment for year six would be calculated over 25 years. Hence, any additional principal payments made during the first five years would result in a lower monthly payment, but no change in the payoff period.

It is possible to shorten the payoff period of an ARM by making extra payments, but you must increase the extra payment at every
payment adjustment date so as to offset the decline in the scheduled payment resulting from prior prepayments. This is a pain, but spreadsheets on my Web site can ease the pain substantially. Each time the rate changes, the borrower can find the extra payment required for a target payoff date at the new rate. The spreadsheets can also be used to monitor the lender's alculations.

Figuring the Payoff Month: Calculators 2a, 2b, and 2c on my Web site will help borrowers who want to pay off early. 2a is for those who want to know when their loan will pay off and how much interest they will save if they allocate a certain amount to extra payments. 2b is for borrowers who want to know how much extra they must pay to pay off their loan within a specified period. 2c is for borrowers who want to know when their loan will pay off and how much interest they will save if they shift to a biweekly payment schedule.

Monitoring the Lender: Many borrowers worry about whether or not lenders have properly credited them for partial prepayments. While I don't think that any lenders misappropriate payments, mistakes happen and it is a good idea to keep an eye out for them. A few lenders have begun to provide borrowers with access to their payment history on the Internet, but it will be a while before this becomes standard practice.

Meanwhile, you can use two Excel spreadsheets I developed for just this purpose that are accessible on my Web site. The spreadsheets can be saved to your computer so you can maintain a permanent record of your mortgage.

The spreadsheets show an entire amortization schedule for an FRM or an ARM, with an empty column for prepayments. The ARM version also has a column for the interest rate. When you enter an extra payment, the entire schedule is recalculated. The resulting balance can then be compared with the balance shown in the lender's statement.

Closure at Payoff: After the mortgage is fully paid, you should receive a “satisfaction of mortgage” from the lender, along with your note. This is the evidence you need that your loan has been paid off. If you don't receive these documents, contact the lender, but give him a few weeks at least. You must also make sure that the lender has filed the satisfaction of mortgage with the county where your mortgage was registered so that it no longer appears on your property record. Check with the county, but give the lender at least six weeks.

If your taxes are escrowed, you must also notify the tax office or offices that henceforth tax notices should be sent directly to you. Also see Biweekly Mortgages.

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