Pay-Down Magic

Pay-Down Magic

Belief that there is a special way to pay down the balance of a home mortgage faster, if you know the secret.

Since many if not most borrowers don't fully understand how mortgage amortization works, they are susceptible to wishful thinking-type myths. As a mortgage counselor, I hear these myths frequently. Most make no sense at all, such as those that advocate early payment of specific future principal payments. A few, however, have some foundation in fact.

Making a Large Extra Payment as Soon as the Loan Closes: According to my respondents, two books promote this as a way to pay off a loan early and save lots of interest. Instead of borrowing $190,000, they suggest you borrow $200,000 and immediately repay $10,000. If the loan is for 30 years at 6%, doing it their way will result in a payoff in 316 months instead of 360 and a saving of $32,042 in interest. These numbers are correct.

The reason for the early payoff and interest savings is that, if you borrow $200,000 and repay $10,000, your monthly mortgage payment is calculated on $200,000 rather than $190,000, making it $60 higher. This additional $60 a month is the entire secret. You will get exactly the same result by borrowing $190,000 and making the payment for $200,000.

This does not mean that the two alternatives are equivalent. If you borrow $200,000 and immediately repay $10,000, you have a required payment of $1,199. If you borrow $190,000, your required payment is $1,139, and the extra $60 is optional. Which is better depends on whether you prefer the discipline of having to make the higher payment or the flexibility of having it optional.

Borrowing the larger amount also increases all the settlement costs that depend on the loan amount, including points and origina-
tion fees, title insurance and per diem interest. These will be calculated on $200,000 rather than $190,000. In addition, you will pay another full month's interest on $200,000 if the lender's accounting system does not recognize an extra payment before the first installment payment is due.

The upshot is that, in an apples-to-apples comparison where the monthly payment is the same, borrowing $200,000 and repaying
$10,000 immediately will cost more than the alternative of borrowing $190,000.

Refinancing into a Simple Interest Biweekly: While the “magical” device described above costs little to those who act on it, the same cannot be said for this one. I have found borrowers who were bankrupted by it. It is a biweekly mortgage with daily interest accrual, as described in Mortgage Scams and Tricks/Strictly Lender Scams/Sell Biweeklies Under False Pretenses.

In the merchandising of this scam, loan officers paint a magical aura around the way their mortgages pay down. They use words
like “reamortize” to connote a unique process that saves borrowers money despite the higher interest rate. In fact, every borrower I have encountered who has taken one of these mortgages has been duped.