How does pre-payment affect an adjustable-rate mortgage?

Question

Some fixed-rate mortgages have their monthly payments pre-determined. For these mortgages, pre-payment of the balance doesn't affect the monthly payment amount but increases the amount of each payment that pays down the balance and reduces the duration of the loan.

As described in this answer, adjustable-rate mortgages pretend the current interest rate will remain the same for the rest of the loan and use the same formula as a fixed-rate mortgage on that rate calculate monthly payments. When the interest rate changes, the formula is re-calculated so the payment amount varies.

If you pre-pay the balance of an adjustable rate mortgage, I see two plausable ways the mortgage could be affected:

• Consistently with the aforementioned fixed-rate mortgages, calculate payments as if no pre-payment were made. The monthly payment would be unaffected but more of each payment would go toward paying down the balance and the duration of the loan would be reduced. This would mean an adjustable-rate mortgage where the rate happens to be fixed would work the same as a fixed-rate mortgage.
• Pay down the balance of the loan on the same schedule as if pre-payment had not been made. As the pre-payment reduced the balance, interest is lower so the monthly payment goes down. The duration of the loan is reduced but not as much as if more of each payment shifted toward paying down the balance.

What is the actual way that pre-payment affects an adjustable-rate mortgage?

Answer 1

When the interest rate of an ARM resets, the payment amount is re-calculated based on the remaining principal, term, and new interest rate. If you pre-paid a portion, your principal amount will be lower than originally scheduled, and thus your payment will be lower than it would have been had you not prepaid.

So unlike a fixed-rate mortgage, prepaying does not shorten the length of the loan but just lowers the payment once the interest rate resets. It also increases your equity, meaning you have less to pay off when you sell or refinance.

This is the typical case - the terms of a specific loan may handle payment resets and prepayments differently. You might even be able to apply for a "re-amortization" to shorten the length of the loan without refinancing, though some lenders do not offer that.

Of course, if you wanted to pay off the loan early, you could always make higher periodic payments than required, reducing the principal further over time, and eventually you will just pay off the loan early naturally.