Reducing mortgage term by paying off a chunk of the principal each quarter - how effective is this?

Question

A family member once told me about a method for reducing the term of a mortgage "significantly".

They didn't know (or I can't remember) the details but it had to do with certain mortgages that recalculate the interest quarterly. From what I remember the idea is to make the monthly payments on time and then pay off a chunk of the principal at the end of each quarter, which results in lower monthly payments the following quarter. Done over and over, this seemingly can shave quite a few years off a mortgage.

I don't know much about mortgages and so my questions are:

• is this as effective as I was told?
• where can I find more information about it?
• how would I ask a bank if they allow it? I can't imagine it being in their interest at all.

My first impression is that if I ever get a mortgage I'd want to do this to not end up paying zillions (of Euros) in interest over 40 years.

Answer 1

You mention Euros, so I'm not sure where your mortgage would be held. In the US, with mortgages I've had, you can prepay at any time without penalty. Any prepayment reduces your interest expense.

This calculator will tell you how much you can save (and how much you can reduce the term) by making prepayments. I don't know how well it will apply to non-US mortgages, which may calculate amortization differently.

This will not (in the US) however, reduce your monthly payments. Your payments will remain the same but the term of the loan will be reduced.

Answer 2

Another way of paying off the mortgage faster is making a payment every two weeks instead of twice a month or monthly. This essentiall results in one payment a year being entirely principal reduction. In addition, interest does not compound as quickly, because you are paying off the principal faster.

Answer 3

Overpaying a mortgage is a pretty effective way of shortening the life of the loan - remember that the interest is calculated on the outstanding balance whenever the interest is recalculated (depending on your loan that can be anything from daily to once a year) so the smaller the outstanding balance, the less interest you have to pay.

The earlier you start this in the life of the loan, the shorter the repayment period will be as the portion of the payment that is allocated to the interest is largest at the beginning.

Answer 4

Be sure to ask your mortgage holder how they would like you to make prepayments. Some mortgage holders get confused if you send in a payment for less than the full monthly note - it may set off panic alarms at the bank.

Some lenders can get even more confused if you send two payments in one month - they may assume the unexpected payment is for the following month and apply the payment to next month's interest instead of paying down the principal. This actually happened to me several years ago - a phone call to the lender cleared things up.

Some lenders may charge a fee to "convert" a monthly note into a biweekly note. IMO, this isn't worth it in terms of my monthly cash flow. I'd rather be obligated to pay monthly but have the option to pay more often when I can than to be obligated to pay more often.

Answer 5

In the States, where prepayment penalties are quite rare, you are welcome to make additional principal payments along with the mortgage any time. This is a snapshot for the first months amortization of a $200K/4%/30yr mortgage:

It's interesting to note that in month one, if you were to pay $289.12 in an extra payment, you would knock a month off the back end. The other way to look at it, is that you get to cross out both Month one and two when making that payment. Next month, you can't skip a payment, but you are in month 3 instead.

In the older days, a 12% rate would have the payment on this same loan over $2000 per month, but it would only take $58 or so to pay that next month's principal. Ironically, today's low rates means prepayments save you less as the math is the exact same as investing for up to 30 years with only 4% interest compounding for you. That's the punchline, the savings is the same rate as you pay on your loan, compounded over the time left on the loan.

Answer 6

It bears noting that if you pay extra/early on your loan, then either your term will decrease or your payments will go down or a lesser combination of both. You can't have the best of both options. If you want the shortest term, you keep making the same payments after your lump payment. If you want the lowest payments, you keep the same term after your lump payment.

Answer 7

How effective is it? It's as effective as your mortgage rate. If your mortgage is at 6%, it's a 6% per year return. The bank will let you pre-pay because, well, your mortgage is not all that special. When you pay back the money, they can just use it for something else. (This is the same reason they let you refinance your mortgage when rates get lower - a more wholesale version of the same thing.)

Now, the bank might possibly have to invest the money at lower rates, but that risk is already baked into the price of the loan when they give it to you, and it's a feature most people (at least in the US) expect from their mortgages. The bank can also buy derivatives on the open market so that if interest rates fall, they make back that money... or they can just risk it, if they're so inclined.