When to Accelerate Mortgage Paydown

Answer
In principle, you should place it where it will earn the highest after-tax and risk-adjusted return.

If you itemize your tax deductions and are in the 25 percent tax bracket, your after-tax return on mortgage balance repayment is 3 percent and it is riskless. In today’s market, that is a good return. An investment account consisting entirely of insured CDs, for example, will earn closer to 1 percent.

On the other hand, if your contributions to the investment account are matched by your employer, you would do much better investing there. If your investment account is invested entirely in a diversified portfolio of common stocks that has earned 9 percent over the last 20 years, your decision should depend on the weight you place on the risk associated with investment in common stock. That in turn depends in part on your time horizon. The longer the period covered by your investment plan, the smaller the weight you should give to the risk of stock price declines as an offset to the high long-run return.

Question

We now have excess funds to apply to our mortgage and are looking for guidance on whether we are doing it right. We’re currently paid six months in advance on our mortgage, plus we have been making additional principal payments with every mortgage payment.

Answer
This questions calls for some definitions. A principal payment is one that reduces the loan balance, resulting in smaller interest charges in subsequent months and reducing the period until final payoff. An advance payment is an interest-free loan to the lender, who holds the borrower’s money until such time as a payment comes due. An advance payment serves no purpose for the borrower.

I have had two mortgages in my life. Both were paid off early with extra principal payments, but in neither case did I make any advance payments. When I spent a year abroad, I gave my mortgage lender 12 checks dated on the first day of 12 consecutive months. These were not advance payments because the checks would not clear before those dates.

Perhaps an advance payment makes sense for undisciplined borrowers who fear that they will spend any surplus funds, leaving themselves short when future payments come due. By paying in advance, they are avoiding temptation by committing themselves irrevocably when they have the money. But I wonder whether such people ought to be homeowners?

A final word to borrowers committed to making extra payments, not advance payments. Don’t double your scheduled payment, because an extra payment that is precisely equal to the scheduled payment can be interpreted by the lender as an advance payment.

Question
My wife and I have an adjustable rate second mortgage which started with Wachovia, then became Wells Fargo in 2006. Although the interest rate changes only once a year, the allocation of the payment between principal and interest swings wildly from month to month. Can you explain why this happens?

Answer
I couldn’t.

Ordinarily the allocation between principal and interest changes very little from month to month, so I asked this particular reader to send me the note and a few monthly statements.

The note answered the question.

The reader has a simple interest loan on which interest accrues daily instead of monthly. On simple interest loans, the allocation of the payment between interest and principal depends on the day the payment is credited. If the borrower pays on the second day of the month, about 95 percent of the payment will go to principal. If he pays on the 15th of the month, about three fifths of it goes to principal. If he pays on the 30th, about one-fifth goes to principal. And if he doesn’t pay until the seventh day of the following month or later, none of the payment goes to principal. This is why some borrowers with simple interest mortgages and sloppy payment habits find after many years that they had not reduced their loan balance at all.

The couple who wrote me were not aware that they had a simple interest mortgage because the monthly statements they received showed only end-of-month figures. That is inexcusable. It should be mandatory that the monthly statements issued by servicers of simple interest mortgages show daily figures.