A frequently asked question is whether a mortgage borrower receives any benefit from paying before the due date. In most cases, the answer is "no," but there are a few exceptions. With simple-interest mortgages, including HELOCs (home equity lines of credit), it does pay to pay early and, under some circumstances, paying early in order to shift next year’s interest into this year could reduce taxes.
The rules when payments are late: On a standard monthly payment mortgage, the payment is due on the first day of the month, and will be credited to the borrower on that day, regardless of when it is received. If the payment is received within the grace period, customarily the first 10 or 15 days, the borrower receives a free ride — no interest accrual — for those days.
If the payment is received after the grace period but within the month, the borrower is subject to a late charge. If the payment is not received until the following month, the borrower incurs a late charge and is reported to the credit bureaus as a 30-day delinquency, but the payment is credited as of the first day of the previous month.
When payments are early: Payments made before the due date are also credited as of that date. This gives the lender free use of the borrower’s money for that period. The borrower who consistently pays two weeks early, for example, is in effect providing the lender with a two-week grace period comparable to that provided by the lender to borrowers who pay late. There is no benefit to the borrower.
Simple-interest mortgages are different: On simple-interest mortgages, interest accrues daily rather than monthly, which changes the rules significantly. As with standard mortgages, payments are due on the first day of the month and late fees are charged on payments received after the grace period.
On simple-interest mortgages, however, interest is due every day. This means that a borrower who pays one day late pays additional interest for that day, and the borrower who pays one day early saves a day’s interest.
The bottom line is that a borrower who consistently pays two weeks early will save money on a simple-interest mortgage. That doesn’t bother the lenders because they know that those are rare birds. Most borrowers pay late.
Borrowers don’t get to choose between standard and simple-interest mortgages; I have never heard of it being offered as an option. Most have standard mortgages, and those with simple-interest mortgages typically didn’t know what they were getting. Borrowers need to adapt their payment habits to the kind of mortgage that they have.
I should note that HELOCs are simple-interest, and most HELOC borrowers do understand that they accrue interest daily. It pays to pay early on a HELOC.
Making advance provision for future payment: Early payment should not be confused with making advance provision for future payments. When I took my family on an around-the-world tour some time ago, I left a set of checks with the loan servicer dated at monthly intervals. This assured that each payment would be made on time, but I was not giving the servicer the use of my money because only one check at a time became negotiable.
A potential tax benefit in paying early: In December, some borrowers who itemize their deductions make their payments for the early months of the following year. This shifts the interest deduction in those months from next year to this year. This can be especially advantageous if the borrower expects to be in a lower tax bracket, or expects the tax rate to be lower next year.
For this to work, however, you need the servicer to agree in advance to credit your account this year for the payments due next year. The end-of-year statement will then show the interest as having been paid this year.
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.com.
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