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March 10, 2003
"I read two books that suggested
making a large payment on your mortgage the day you close. They said it saves
you many months of payments and thousands in interest. They also said that the
lender will try to discourage you and would ask why you just don�t reduce the
loan by the same amount. We asked the loan officer at our credit union, and that
is exactly what he said! We are taking a 30-year loan at 6% for $200,000,
putting 20% down. We have an additional $10,000 that we are thinking about using
to pay down the balance on the day we close, as the books recommend. What do you
think?"
I think that this is one more fairy tale
about magical ways of paying off a mortgage that purport to save money. Every
time I run into one I try to shoot it down, but new ones keep popping up.
This particular fairy tale is a little more
compelling than some others because it is based on a sliver of truth. However, I
doubt that, once you understand what is going on, you will elect to proceed. In
an apples-to-apples comparison, borrowing $200,000 and repaying $10,000
immediately will cost you a few hundred dollars more than the alternative of
borrowing $190,000.
Let�s assume that your loan for $200,000
closes on March 15, and immediately after closing you pay the lender $10,000.
What does the lender do with the $10,000? While this is not altogether clear,
let�s assume that the payment is immediately credited to your loan balance.
That�s the best possible outcome for you. It means that at the 2pm closing,
you owe the lender $200,000, but at 3pm, you owe only $190,000.
The sliver of truth behind the books�
recommendations is that your $200,000 loan with the immediate $10,000 payment
will pay off in 316 months whereas if you had borrowed $190,000 the loan would
run for the entire 360 months. Furthermore, in the recommended case you will pay
$32,042 less interest.
How can it be that by borrowing $200,000 at
2pm and paying off $10,000 at 3pm, you pay $32,042 less interest over the life
of the loan than if you had borrowed $190,000 at 2pm? In the first case, your
monthly mortgage payment is calculated on $200,000, which is $60 higher than the
payment calculated on $190,000. This additional $60 a month is the entire
secret. If you borrow $190,000 but make the payment for $200,000, you will get
the same result as borrowing $200,000 and immediately repaying $10,000.
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 $1199. If you borrow $190,000, your required payment is
$1139, and the $60 additional 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.
Wherever you come out on this, you should
recognize that borrowing the larger amount will increase your settlement costs.
Costs that depend on the loan amount, including points and origination fees,
title insurance and per diem interest will be calculated on $200,000 rather than
$190,000. Per diem interest is the interest paid at closing for the period
between the closing date and the first day of the following month.
In addition, it is very likely that you will
pay another full month�s interest on $200,000. The accounting systems used by
most lenders to service mortgages will not recognize an extra payment before the
first installment payment is due. This means that the interest included in the
first payment due May 1 will be calculated on $200,000.
If you really like being required to make the
larger payment, and don�t mind paying a little more in settlement costs for
the privilege, you want the costs as low as possible. Ask the lender whether a
payment to principal can be credited to the balance before the first payment is
made. If the answer is "yes", ask when the payment must be received.
If it is "no", hold onto the money until the first installment payment
is due, and pay it then.
Copyright Jack Guttentag 2003
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