The following was written by a finance professor at a major university, who shall remain unnamed until the said professor comes out to claim ownership. It was published yesterday by a blog run by several well known university professors.
I’m quoting the full text because it was disowned by the blog that published it. A blog editor removed it as if it never existed. If and when the original blog restores it, I will replace the quoted text with a link.
Want to give your bank an interest-free loan?
When I went to complete my most recent re-financing, my lender offered me the option of making an extra few payments a year; the logic he said was that I could complete my loan a couple years earlier and thus save myself thousands in interest. Sounds like a good idea, right?
This strategy has been promoted by major news outlets like the WSJ. The problem is that when you pay down your loan, your bank rarely ‘recasts’ your mortgage. Recasting is the re-calculation of interest payments based on the remaining balance of the loan rather than the amount you currently owe.
Thanks to the pre-payment, you’re left with a high-interest loan!
So why does it matter? Consider a homeowner with a $250,000 loan at 5% interest over 30 years. Interest accrues according to a schedule such that the borrower pays the bank the equivalent of 5% of the remaining balance in each year. So, the first year, interest is $12,416. Type ‘mortgage amortization schedule’ into any search engine to get a list of sites to calculate this.
Now, imagine that our homeowner sends the bank an early payment check on month 12 of the loan for $100,000. Most borrowers probably assume that the interest payments now accrue at 5% of $150,000 (the remaining principal balance), or $7,111 in the first year after the prepayment.
However, banks almost universally apply the $100,000 to the END of the amortization schedule, meaning that your mortgage payments will end a few years earlier, but your interest will continue to accrue on the original $250,000 balance. A loan rate greater than 8%!
So basically you just gave a $100,000 interest free loan to your bank. This loan could sit with the bank for 10-20 years or more.
So how much money is at stake? To the credit of the WSJ, two weeks after the article on pre-paying, they suggested re-casting as a strategy to lower monthly payments. In that WSJ article, they mentioned that fewer than 200 mortgages out of 10 million are re-cast each month at JP Morgan Chase. The numbers are similar at other banks.
If you have a $100,000 to put towards your mortgage, put those extra payments in an risk-free interest-bearing account until you have enough to pay off the full loan. By then, those extra payments will be worth much more, and you still would have shortened the life of the loan.
If you’ve had a mortgage and you made additional principal payments, you should know this is completely wrong. The extra principal payment goes toward the outstanding principal immediately when it’s applied. The interest portion of the next regular monthly payment goes down.
How a finance professor could get it so wrong was surprise number one, but I can understand. Maybe the professor never prepaid any mortgage before. When you write from what you read in the newspaper as opposed to from personal experience, you can get it wrong.
How the professor handled the error after being so wrong was surprise number two. Nobody is perfect. Making a mistake is not a big deal, even if you are finance professor. Admit the mistake, correct it, and move on. Wiping it clean as if it never happened isn’t the right way.