Partial Prepayments (or Paying Off Early)

Making a payment larger than the fully amortizing payment as a way of retiring the loan before term. Making Extra Payments as an Investment: Suppose you add $100 to the scheduled mortgage payment. This makes the loan balance at the end of the month $100 less than it would have been without the extra payment. In the months that follow, you save the interest on that $100. Since the interest payment that you would have made is determined by the interest rate on your mortgage, the yield on your $100 investment is equal to that rate. Absent any prepayment penalty, principal repayment yields a return equal to the interest rate on the loan. A prepayment penalty would reduce that yield. Factoring Taxes into the Equation: Many borrowers want to reduce the yield on mortgage repayment by the amount of the lost tax saving. If the borrower is in the 36% tax bracket, for example, his or her after-tax yield on an 8% mortgage is (1 - .36) x 8, or 5.12%. If the yield on mortgage repayment is being compared with the yield on other taxable investments, however, it doesn't matter whether yield is measured before tax or after tax. If mortgage repayment is compared with a 6% taxable bond, for example, the before-tax comparison is 8% versus 6%, while the after-tax comparison is 5.12% versus 3.84%. The conclusion, that mortgage repayment earns the higher return, remains the same. On the other hand, if the alternative investment is tax-exempt, you should compare only after-tax yields. Partial Prepayments Versus Other Investments: To determine whether paying more principal is a good investment, the yield should be compared with the yield on alternative investments, with allowance for differences in risk. An investment in mortgage repayment carries zero risk. Mortgage repayment will always carry a higher return than other risk less investments insured certificates of deposit and U.S. government securities. However, investments that shelter income, such as contributions to a 401 plan, will usually generate a higher after-tax return than mortgage repayment. In addition, a diversified portfolio of common stock may yield 12-15% over a long time horizon, provided the borrower is prepared for the risk of short-term fluctuations in portfolio value. Seniors Versus Juniors: Investing in mortgage repayment is generally smarter for a senior than for anyone else. Many seniors no longer have income to shelter; even those that do have a lower after-tax return because the tax deferment period is short. Furthermore, where a diversified portfolio of common stock is a prudent risk for people in their 30s or 40s, it is less prudent for those in their 70s or older. A single stock market tumble could crack their nest egg. For this reason, mortgage repayment is a preferred investment for many older investors. This does not necessarily mean, however, that they should repay the entire mortgage balance at one fell swoop, as explained below. The partial prepayment decision and the repayment in full decision are very different. Partial Prepayment Versus Repayment in Full: Whether to allocate excess cash flow to mortgage repayment is a relatively easy decision because borrowers get to change it every month if they want. They prepay if the mortgage rate is higher than the rate that can be earned this month on newly acquired financial assets. Next month, the investment rate could be higher and the decision different. Whether to repay the entire mortgage balance by liquidating financial assets, in contrast, is a single, irrevocable decision. Either the assets are liquidated to pay off the mortgage or they aren't. While the principle,, that the decision should be based on comparison of the mortgage rate and the investment rate, is the same, borrowers can't adjust to future changes in the investment rate. They have to look ahead and anticipate what these changes might be as well as how long they will be around. In general, the sooner interest rates increase, the larger the increase when it happens, and the longer the borrower expects to live, the weaker the case for liquidating assets to pay off the mortgage. Seniors having to make this decision may find it instructive to play with the spreadsheet. Effect of Early Payment on Monthly Payments: Extra payments to principal affect different types of mortgage differently. FRMs: On an FRM, extra payments shorten the period to final payoff but do not affect the monthly installment payment. This is sometimes a source of frustration to borrowers who come into a sizable amount of money that they would like to use to reduce their installment payment burden. They can't do it except by refinancing the reduced loan balance. On balloon mortgages, the monthly installment payment is not affected either. However, the balance that must be rolled over at the end of the five- or seven-year rollover period is lower than it would be otherwise. And this means that the new installment payment is lower than it would be otherwise. ARM's: Where it is difficult to reduce the monthly installment payment on an FRM, it is difficult to shorten the payoff period of an ARM. The reason is that every time the mortgage payment is recalculated to reflect changes that have occurred in the interest rate, the calculation assumes that the loan will pay off in the period remaining of the original term. Closure at Payoff: After the mortgage is fully paid, you should receive a 'satisfaction of mortgage' from the lender, along with your note. This is the evidence you need that your loan has been paid off. If you don't receive these documents, contact the lender, but give him a few weeks at least. You must also make sure that the lender has filed the satisfaction of mortgage with the county where your mortgage was registered so that it no longer appears on your property record. Check with the county, but give the lender at least six weeks. If your taxes are escrowed, you must also notify the tax office or offices that henceforth tax notices should be sent directly to you.