“A friend was telling me of an interesting way to shorten the term of a mortgage. He says that I could instruct my bank to pay the interest portion of, say, the next 10 months of regular payments. My next payment would be for the 11th month on my amortization schedule. The result would be to save the next 10 months of regularly scheduled interest, saving me thousands of dollars and reducing my loan term by 10 months. Is this possible?”
Your friend is confused. If you told the servicing agent (SA) you wanted to pay the interest for the next 10 months, you would get a blank stare. Interest is calculated each month on the balance at the end of the preceding month. Hence, interest is not known for future months, since it depends on what happens to the balances in the preceding months.
You can add up the interest payments shown on an amortization schedule for the first 10 months, but that number is conditional on your making the first 10 scheduled (required) payments on time, with no extra payments. For example, if you took a $100,000 loan at 6 percent for 30 years, your scheduled interest payments over the first 10 months, as read off an amortization table, would add to $4,977. But if you gave this to the SA in addition to the regular monthly payment for the first month, the SA would not use it to pay future interest, nor would you want it to.
The SA would consider the $4,977 an extra payment like any other. Aside from the possibility that he/she might be curious as to why it was not rounded off to $5,000, where the figure came from has no significance to the SA.
When the SA receives a payment above the scheduled payment, there are only three things it can do with it–other than to steal it. First, they can use it to reduce the current balance. For example, the $100,000 loan at 6 percent and 30 years has a scheduled payment of $599.56. Following the first payment, the balance is $99,900.44. (The interest in month 1 is $500, leaving $99.56 to reduce the balance). If another $4,977 is added to the payment, the balance would drop to $94,923.44.
The balance reduction means you no longer pay interest on that $4,977, so a smaller portion of subsequent payments is allocated to interest and a larger proportion to principal. The loan would pay off in 316 months instead of 360, and save $21,724 in interest. These numbers are taken directly off the first spreadsheet on my Web site.
Ordinarily, this is what you want the lender to do with the extra payment, and it must be what your friend has in mind. Borrowers do this all the time and it requires no arcane procedures. Under some circumstances, however, a few simple safeguards are in order to prevent a misunderstanding.
The second possibility is that the SA will assume you want the money held for future payments. This is a plausible assumption when the extra payment is an exact multiple of your scheduled payment. For example, if you send a check equal to $1,199.12, which is exactly the amount of two scheduled payments, they could plausibly assume that you are making an additional monthly payment, and hold half of it for a month. To avoid this, do not make extra payments an exact multiple of the scheduled monthly payment.
If you send a check for $5,576.56, which is the sum of $599.56 and $4,977, the SA could assume that you intend to make nine payments in advance with a little left over. If they did that, the savings from an immediate reduction in the loan balance would disappear. While the assumption that this is your intent is too far-fetched to be credible, there are a few larcenous SAs out there, so it doesn’t hurt to be careful. Put the $4,977 on a separate check and mark it “applicable to current principal.”
The third thing the SA could do is to hold the payment until the balance is paid down to the same amount, and then apply it. In the example, your balance would reach $5,254 in month 351, so they could apply the $4,977 at that time. I once heard of a credit union that did that because it didn’t know any better. It comes close to stealing, however, and any major institution that did it would face class-action suits big time.
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.
What’s your opinion? Send your Letter to the Editor to email@example.com.