How Large Prepayments Impact Mortgage Payments

FAMP is the level of monthly payment required to repay the mortgage fully over its remaining term.

Many borrowers would like a mortgage on which the monthly payment would drop to the new, lower FAMP following a large payment to principal and are disappointed when they find they don’t have one.

The rules governing payment adjustments following extra principal payments vary with the type of mortgage.

Fixed-rate mortgages, or FRMs, adjustable rate mortgages, or ARMs, and home-equity lines of credit, or HELOCs, all work differently in that regard.

Fixed-Rate Mortgages

FRMs are the most rigid in that extra payments do not affect the required monthly payment at all.

For example, if you borrow $100,000 for 30 years at 3 percent, your FAMP is $422. Pay this amount every month, and you pay off the loan in 30 years.

If you make an extra payment of $10,000 in the second month, your payment in the third month and all subsequent months remains $422. Your loan will pay off in the 305th month instead of the 360th month, but until then, you receive no payment relief.

Of course, the lender can always agree to modify the contract, and some will do it for a fee.

For example, the payment could be dropped to $379, which is the new FAMP following the $10,000 payment to principal.

Mortgage With an Interest-Only Option

There is one exception to the rigidity of FRMs noted above. If the FRM is interest-only for a period, which many were prior to the financial crisis, the payment should decline in the month following an extra payment.

For example, if the $100,000 loan at 3 percent was interest only in the second month when the borrower made a $10,000 payment to principal, the interest payment should decline from $250 to $225 the following month.

In many cases, however, the payment adjustment was delayed because the lender’s servicing system could not handle the transaction properly. Such delays could range anywhere from a few months to the end of the interest-only period, which usually was five or 10 years.

Interest-only is no longer an option on prime mortgages, and few new ones are being written.

Adjustable-Rate Mortgages

With an ARM on which the borrower is making the FAMP, extra payments change the monthly payment at a rate adjustment.

That happens in the 37th month on a 3/1 ARM, the 61st month on a 5/1 ARM, the 85th month on a 7/1 ARM, and the 121st month on a 10/1 ARM.

On the rate adjustment date, the payment is recalculated using the new rate, the period remaining of the original term, and the outstanding balance which will reflect any extra payments made in prior months.

Consider a 5/1 ARM for $100,000 at 3 percent, which has a FAMP of $422. That payment holds for the first 60 months, regardless of any extra payments made within that period.

If the borrower made an extra payment of $10,000 in the second month, assuming the 3 percent rate is unchanged, the new FAMP will be $379, but the borrower must wait until the 61st month to see it.

ARMs become more responsive after the initial rate period ends because rate and payment adjustments then occur every year or every six months. This means that extra payments reduce the monthly payment within a year or less.

Home-Equity Lines of Credit

The monthly payment on a HELOC is highly responsive to a large principal payment.

During the initial phase of a HELOC, which usually runs for 10 years, the borrower pays interest only, though on new HELOCs some lenders now require a higher payment.

In either case, since the required payment is a percent of the outstanding balance, a large principal payment results in an immediate reduction in the required payment.

At the end of the initial rate period, borrowers enter the payoff period, during which they must begin paying the FAMP calculated over the remaining life of the HELOC, usually 20 years.

The payment increase required as they switch into payoff mode is often substantial, since in the typical case no or very little principal payments had been made during the first 10 years.

While a payment larger than the FAMP during the payoff period will cause the FAMP to decline the following month, this is academic to HELOC borrowers who have trouble paying the FAMP.

Concluding Comment: Do You Really Want a Payment-Responsive Mortgage?
Readers should not infer from this article that mortgage payment sensitivity is always a desirable feature.

Reducing the monthly payment is a short-run goal that conflicts with the long-run goal of getting out of debt as soon as possible.

While prioritizing the short-run goal is reasonable for borrowers who are having trouble making the current payment, it should be avoided by borrowers who don’t really need payment relief.