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Mortgage Repayment Myths and Truths

The Mortgage Professor: Don't be tricked by mortgage repayment 'tricks'

March 3, 2016

By JACK GUTTENTAG The Mortgage Professor - Tribune News Service

The phrase "weird trick" seems to have great sales appeal, judging from the frequency with which it appears in my email inbox.

I see weird tricks for lowering blood pressure, losing weight, improving sexual prowess, reversing diabetes and accelerating the pay-down of a mortgage balance.

This last group of tricks I hear about mainly from readers, who have been told about the trick by friends, loan officers or Internet hustlers.

Some examples:

Q: Will borrowing a larger amount than I need and repaying the excess right after closing allow me to pay off my mortgage early?

A: Yes, this trick works by generating a larger payment than the one needed to amortize the balance over the term.

For example, if you need a 4 percent 30-year loan of $280,000 to purchase your house but borrow $300,000 instead and immediately after closing repay the additional $20,000, your required monthly payment will increase from $1,337 to $1,432.

The larger payment results in payoff in 317 months instead of 360, with a savings of $27,214 in interest.

But this trick imposes an unnecessary cost on the borrower.

Settlement costs that depend on the loan amount, including points and origination fees, title insurance and per diem interest, will be calculated on $300,000 rather than $280,000.

In addition, because of the way that loan servicing systems work, it is very likely that the borrower will pay a full month's interest on $300,000, even if $20,000 is repaid the day after closing.

The alternative, which for most borrowers makes more sense, is to borrow the $280,000 needed, and make a payment of $1,432 instead of the required $1,337.

You will pay off on the same schedule as using the trick, enjoy the same reduction in interest payments, while avoiding the increase in settlement costs.

The only borrowers for whom the trick makes sense are those who do not have the discipline needed to make a payment that is consistently larger than the required payment.

They need to lock themselves into the larger payment, which the trick does by making the larger payment obligatory rather than discretionary.

Q: Will paying mortgage interest in advance shorten the payoff period?

A: No, because there is no way to pay interest in advance.

Interest is calculated each month based on the balance at the end of the preceding month. Interest is not known for future months, since it depends on what happens to the balances in the preceding months.

When you make a payment that is larger than the required scheduled payment, there are only three things the lender can do with the excess.

First, they can accept it as payment for any amounts owed to them. For example, if you owe them for late fees, or if your escrow account requires replenishment, they will probably use the excess for those purposes.

The second thing they can do is apply the excess to the loan balance, which will save on future interest and shorten the period to payoff. Ordinarily, that is what the borrower wants to happen.

The third thing the lender can do is assume that the borrower is making scheduled payments early, which would mean that the lender can invest the funds until they are needed. There is seldom if ever a good reason for a borrower to do this.

The lender might nonetheless assume that the borrower intends to make scheduled payments early if the excess is an exact multiple of the scheduled payment.

If your monthly payment is $640.32 and you have extra money that you want to use to reduce the loan balance, send any amount except $1,280.64, because that is exactly equal to two scheduled payments.

Q: Is it true that the payoff period of a mortgage can be cut in half if the borrower doubles the principal payment each month?

A: Yes, it is true.

But last week I pointed out the formidable downsides of this scheme, the most important of which is that the required extra payment increases every month.

Hence, the only borrowers who are able to use it successfully are those who can depend on a constantly rising income.

Q: Is it true that a second-lien home equity line of credit (known as a HELOC) or a (unsecured) credit card can be used to pay down the balance on a first mortgage well before term?

A: A number of schemes focus on exploiting the difference between mortgage balances calculated only once a month and HELOC or credit card balances that are calculated daily.

For example, a mortgage borrower who also has a HELOC uses all or most of her paycheck to pay down the mortgage balance and funds current expenses by drawing on the HELOC. If the interest rates are the same, the interest charge on the HELOC, because it is based on the average balance during the month, will be only about half of the interest saving on the mortgage.

The net savings, however, are small unless the borrower also makes additional loan repayments. Some borrowers may find the tightly structured set of procedures provided by these programs to be helpful in managing extra payments, but to others they are a needless hassle.

About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.

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Copyright (c) 2016, The Mortgage Professor

Distributed by Tribune News Service.

This story was distributed by TNS - Tribune News Service
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