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I have a mortgage, fixed interest rate, 25 years. I saved some money and I want to prepay part of the loan. The bank asks me to choose between 2 options:

  1. Keep the monthly payment the same, and reduce the lifespan of the loan.
  2. Reduce the monthly payment, and keep the lifespan of the loan.

Both options cost the same fee of 60 NIS (approx $18 USD).

The bank default is option 1. Why is it better for the bank? What is better for me? (Assuming I can afford any option)

TTT
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Itamar
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3 Answers3

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First, I will briefly explain how mortgage payments work. Then we will look at how the two different options you have affect those payments.

When you take out a mortgage, you have borrowed a sum of money at a certain interest rate. The interest on that amount of money needs to be paid by you every month. If all you did was pay the interest, you would never pay off the loan. Instead, in addition to paying the interest due, you are also paying some amount toward the principal of the loan. The next month, your interest charge is a little less than the previous month (because there is less loan principal accruing interest), and a little more of your payment goes toward the principal. When you first took out the loan, the bank calculated exactly what the monthly payment needed to be so that the monthly interest charge would be paid and your loan would be paid off in 25 years.

When you make an extra payment toward your loan principal, the interest charge next month will be less, because the size of your loan is less. As a result, the bank is offering two different options:

  1. Option 1 is to keep your monthly payment the same. But because your interest charge is less, more of this payment goes toward reducing your principal. As a result, your mortgage will be paid off quicker.

  2. With Option 2, the bank uses the savings in interest charges to lower your monthly payment. The monthly payment is recalculated so that your loan is paid off in the original 25 years.

Now, to your question: Which option is better?

Option 1 will save you more interest over the life of the loan and will get you out of debt quicker.

The advantage to option 2 is the lower monthly payment. However, because the length of the loan is longer than with option 1, it will cost you more in interest.

It seems to me that you are not having any trouble making your current monthly mortgage payment. (You were able to save up this extra lump sum to apply to your mortgage.). Because of this, I recommend option 1, which saves you money and gets you debt free sooner.

Ben Miller
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I will start by ignoring the fee. In that case, if you take option 2, you always could continue to pay your mortgage at the original rate (prepaying a little each month), which will come out equivalent to option 1. But you also have the flexibility of paying less in some months if you need the cash flow. So option 2 is mathematically superior to option 1.

In your case, where you have to pay the fee to prepay, you probably don't want to prepay every month. But the fee you're quoting is not all that large. You could consider make a lump sum payment every year or two out of the money you save from your smaller mortgage payment. If you did that, you would not be too far off where you are in option 1.

That means option 2 is probably superior to option 1 from a purely mathematical standpoint — if you want, it can leave you in almost the same place financially, but it also gives you more flexibility in the short term. That being said, there are a few reasons why you might take option 1:

  • Psychology. If you're worried that you might waste the extra money you get every month, you might want to go with the plan that forces you to put it into your house instead.
  • If you're certain that you'll want to make a payment of the original size every month, then that flexibility might be worth very little to you. Then you can save money in fees by going with option 1. (Probably if you keep doing option 2, you'll eventually reduce your payment to the point where this is true.)
Micah
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Maybe you should calculate the time values of your repayments in both the cases. Thus you will be able to find how much you are to going to lose from your net worth. The lesser the better. Let me explain how to calculate the time value of repayments.

Example: Let us assume you are pre-paying $P. Let the risk free rate (consider a realistic savings account) in your locality be R%. Let the repayment amounts every month after current month be $A. Assume you have N years remaining to close the loan.

Let $T be Time value of your repayments (i.e Present worth of all your future repayments).

$T = $P + $A/(1 + R/100)^1 + $A/(1 + R/100)^2 + $A/(1 + R/100)^3 .... + $A/(1 + R/100)^N

Calculate $T for both your cases. The lower is better.

Kannan
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