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.
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Yeah, as I was reading this, I was thinking “That guy has no idea what he’s talking about.” Interesting little turn of events.
Robert Muir says
It didn’t take long to figure out who it was. He sure looks young for a professor!!
Hmm. Interesting. A bit of googling reveals who it is. How embarassing.
While we are at it…May this is the professor who wrote the article: http://ecohencole.weebly.com/
I accept no responsibility for the accuracy of this information. If and when proved incorrect please remove the post.
Roshawn @ Watson Inc says
How embarrassing. I had to look up the original entry and blog author.
Can you link to the “blog run by several well known university professors”?
Agree that pretending it didn’t happen isn’t the right protocol, especially for academics. I wonder where he got this idea.
Riley Dutton says
So, for those of us who stumbled across this article and don’t know much about amoritizations…it IS a good Israel put extra money toward your mortgage payment, right? You end up paying less interest and paying off the loan sooner?
Just making sure…
Harry Sit says
@Jonathan – Those several well known university professors include law professors. I don’t want to bring unnecessary attention to them. If you Google the title of the quoted post you will find the blog, as others apparently have done.
It’s easy to understand where the professor got the idea. He read an article on WSJ about recasting, which said it’s very rare for banks to recast loans after a principal prepayment. He took it to mean that banks stick to the original amortization schedule and don’t recalculate interest after a principal prepayment. It’s just a misunderstanding of what recasting means. However, I should note that the authors on that blog are usually on the other side of banks by their profession. They see the ugly side of banks every day. It’s only natural for them to assume banks always do sneaky things.
@Riley Dutton – Yes, when you prepay a mortgage, you do end up paying less interest and paying off the loan sooner. You are getting a guaranteed return equal to the mortgage rate. It’s often the highest guaranteed rate you can get anywhere. You may be able to invest the money for a higher return by taking higher risk, but as we all know, higher risk does not necessarily bring higher returns. Consider prepaying mortgage after maxing out all tax advantaged contributions (401k, IRA, etc.).
Just to be clear, recasting means that you can put in extra money towards principal and asked the bank to reduce your monthly mortgage payment?
If you don’t ask for recasting, it means that your monthly mortgage payments stay the same but the percentage of that mortgage payment goes toward interest change?
I didn’t know recasting exist, I just assume that if you make extra payments, your monthly mortgage payment stays the same but you will pay off your loan sooner. Thanks to the professor’s goof, I learn something new today !
To be honest, I had a bank do mostly what this guy was saying in that I made extra payments and they incorrectly accounted them against interest. I made them correct it, and it took a couple of tries to get the books right, but they eventually did.
It still wasn’t at the end of the loan, but it was sort of like an interest free loan to the bank.
Harry Sit says
@Beans – Yes to your two questions. After recasting you get a smaller monthly payment, but your loan won’t be paid off sooner and you will pay more interest than you do if you don’t recast. It sort of defeats the purpose of paying additional principal. Most people prepay mortgage because they want to pay it off sooner and pay less interest.
@TFB – No problem. I found it… the name of the blog is just too ironic.
Debbie M says
The method described above was very similar to the method my bank used when I prepaid my first car loan. They pretended like they were looking at a chart showing total amount paid versus length of loan for a given interest rate, even though they had actual computers and could have computed the correct amount. As recommended by that article, I would have been better off waiting until I had all the money (and earning interest on it myself). My bank called it the “rule of 72’s,” which is really just a method of calculating your whole interest payment.
My current housing prepayments are working as expected–the bank actually tells me how much principal they think I have remaining, and it matches the figure I calculate.
Harry Sit says
Debbie M – I think you meant Rlue of 78s. Rule of 72 is a shorthand for calculating how long an investment will double in value at a given rate of return. According to that Bankrate.com article published in 2002,
“Fortunately for consumers, simple interest loans are now the norm in the auto financing business. The vast majority of auto lenders do not use pre-computed auto loans and they do not use the Rule of 78s method to calculate prepayments.”
Also according to that article Rule of 78s were banned in 1992 for loans longer than five years. They are also banned for loans of any length in 17 states.
Even under Rule of 78s, you get some credit for prepaying — not the full credit as you deserve but still some credit. Our professor said you don’t get any credit at all.
very interesting post. He must be a young professor.