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August 18, 2000,
Revised August 4, 2004
"After reading
several of your articles on paying off mortgages early, I came to the
conclusion that I really didn't understand the basic rules of mortgage
accounting. Can you explain them in a simple way?"
Let me
try. After reading the account below, readers are encouraged to
develop an actual amortization schedule which will allow them to see
exactly how the numbers change. They can do that using one of my
calculators. For straight amortization without extra payments, use
my calculator 8a, Loan
Amortization Including Tax Savings. To see how amortization is
impacted by extra payments, use 2a, Term-Shortening
and Interest-Savings From Making Extra Payments.
If you want to experiment with
different payments and/or maintain a permanent record of your loan, download
one of my spreadsheets,
Extra
Payments on Monthly Payment Fixed-Rate Mortgages or
Extra
Payments on ARMs. Unlike the calculators which can't be moved from where
they are, the spreadsheets can reside permanently on the hard drive of your
computer.
The accounting for amortized home
loans assumes that there are only 12 days in a year, consisting of the
first day of each month. Your account begins on the first day of the month
following the day your loan closes. You pay "interim interest"
for the period between the closing day and the day your record begins.
Your first monthly payment is due on the first day of the month after
that.
For example, if your 6% 30-year
$100,000 loan closes on March 15, you pay interest at closing for the
period March 15-April 1, and your first payment of $599.56 is due May 1.
The payment is allocated between
interest and reduction in the loan balance. The interest payment is
calculated by multiplying 1/12 of the interest rate times the loan balance
in the previous month. 1/12 of .06 is .005. The interest due May 1,
therefore, is .005 times $100,000 or $500. The remaining $99.56 is used to
reduce the balance to $99,900.44.
The process
repeats each month, but the portion of the payment allocated to interest
gradually declines while the portion used to reduce the loan balance
gradually rises. On June 1, the interest due is .005 times $99,900.44,
or $499.51. The amount
available for reducing the balance rises to $100.06.
While the payment is due on the
first day of each month, lenders allow borrowers a "grace
period", which is usually 15 days. A payment received on the 15th
is treated exactly in the same way as a payment received on the 1st.
A payment received after the 15th, however, is assessed a late
charge equal to 4 or 5% of the payment.
When borrowers elect to increase
the amount of their payment, the increment reduces the balance by the same
amount. For example, if the borrower paid $699.56 on May 1, the balance
would drop by an additional $100 to $99,700.38, which in turn would reduce
the interest due in June to $498.51.
Extra payments that are
made later in the month might have the same effect, or might not be
credited until the following month, depending on the lender. To be
credited within the same month, extra payments have to be received before
the Nth day of the month, but N varies from one lender to another.
These rules are advantageous to
many, perhaps most borrowers because of the backdating of payments to the
first day of the month. Thus, the borrower who pays $599.56 on May 15 has
the use of $599.56
free of interest for 15 days. The same is true of extra payments received
before the Nth day of the month.
My
mail-box, however, is stuffed with letters from borrowers whose needs are not
met by this instrument. The major problem is the absolute rigidity of the
payment requirement. Skip a single payment and you accumulate late charges until you make it up. If you skip May, for example, you make it up with 2
payments in June plus one late charge, and you record a 30-day delinquency
report in your credit file. If you can�t make it up until July, the
price is 3 payments plus 2 late charges plus a 60-day delinquency report
in your credit file. Falling behind can be a slippery slope into
foreclosure.
Payment rigidity also prevents
many borrowers from organizing their personal finances in the best way.
Some examples from my mailbox:
Borrower A wanted to use a
bequest to reduce the monthly payment on a fixed-rate mortgage. No
way. If A used the bequest to prepay principal, it would shorten the
period to term, not reduce the payment.
Borrower B wanted to use a
bequest to reduce the term on an adjustable rate mortgage. No way. If
B used the bequest to prepay principal, it would reduce the payment,
not shorten the term.
Borrower C wanted to double
his payment in December when he receives his bonus and skip a payment
in August when he has no income. No way. If C used the extra payment
in December to prepay principal, he still had to make the payment for
August.
Borrower D is paid twice a
month and wanted to make his mortgage payment twice a month. No way.
Borrower D must bank his mid-month payment and pay the lender once a
month.
No one instrument will meet
everyone�s needs. Many borrowers who actively manage their family
finances, however, are ill-served by the current amortized mortgage.
Copyright Jack
Guttentag 2004
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