Mortgages: Interest Calculation/Recalculation

[catccc]

Further clarification on what I DO understand... Yes, the mortgage payment will be the same unless you recast. Got that. The interest/principal breakdown will change each payment. Got that.

The proportion to which the breakdown changes and whether it is affected by extra principal payments, that was my original question. And it seems overwhelmingly that payments subsequent to an extra principal payment are indeed affected.

Now that you've all brought these points up, I see that my inquires to others were probably subject to much interpretation, would would explain such varied responses...

Another thing, I did misunderstand the recasting process. I thought it meant they'd recalc amortization with the loan ending earlier, not lowering the payment w/ the loan ending at the same time.

Anyway, so this is all very good. This means that going for a 30 year will probably allow the flexibility I want w/o being locked into an early payoff. Now, just need to find a house to buy... thanks all for the assistance!

 

[rescueme]

I think something is getting lost in translation. To recast or reamortize is different than making extra payments ( as I understand it ). Recast changes the monthly payments which results in a new amortization schedule. Paying extra, the monthly payment stays the same but the allocation between principal/interest changes. They can restrict extra payments or charge prepayment penalties. As others said , get it in writing and get to the details in the documents.

Correct.

We paid off our current home's note, which was for a 30-year term but was retired in 5.5 years.

The only thing that you have to watch is that the bank/CU credits your additional payment as a reduction in principal, not just paying your next month's payment early. To manage that, I always made/submitted two separate checks. Additionally, since I did it in person at the local S&L, I could ensure there was no confusion.

 

[catccc]

Correct.

We paid off our current home's note, which was for a 30-year term but was retired in 5.5 years.

The only thing that you have to watch is that the bank/CU credits your additional payment as a reduction in principal, not just paying your next month's payment early. To manage that, I always made/submitted two separate checks. Additionally, since I did it in person at the local S&L, I could ensure there was no confusion.

Wow, congrats on the aggressive paydown! And thanks for the tip.

 

[scrabbler1]

Late to the dance, but I agree that DJRR's reply is the best among a set of very good ones.

I took out my first mortgage, a 5-yr ARM, back in 1989. In 1992, I refinanced it into a 1-yr ARM but paid down a small part of added principal just before the refi went through. This added principal changed the expected P/I split in my last regular monthly payment so the old lender refunded to me a tiny part of it when the 2 bank's lawyers met to finish the deal.

In the mid-1990s, my monthly payment changed once a year when the interest rate changed. In some of those years, I paid down some extra principal so the P/I split changed from its original glide path (from the start of the 12-month period in which the new interest rate was in effect). I was always able to figure out to the penny what my total interest paid was for the calendar year before I received the 1098 form, even if I made an extra principal payment (the P/I glide path sometimes changed 2 or 3 times in a calendar year). By 1998 I had paid it off.

As rescueme mentioned, it was important to differentiate additional principal from an early payment. But because I had ACH payment for the regular monthly ones, I used the payment coupons solely for additional principal (the lender told me to do it that way) and there was no problem.

 

[Finance Dave]

Okay, so I have one Yes, I'm correct, and one No, you are not.

Anyone else care to weigh in? If you can confirm or deny my understanding, can you let me know how you know? (i.e. "that is how my mortgage seemed to work" weighs less heavily than "I've been a mortgage loan officer for 15 years.") At any rate, I do appreciate all responses.

I don't see anyone saying you're "correct"...he just said that's the way he did it.

I agree with p4buski. It's not that they "recalculate" anything, but it will come off the principal balance regardless of how you do it.

The one clarification is that yes, you do avoid the interest when you pay additional principal...but it's a bit misleading. You are saving future interest.

For example, let's say you pay additional in the very first month of your 30-year loan, and don't pay any more additional after that. Then your final payment, 359 payments later, would be smaller (or perhaps zero, depending on how much additional you paid). You really aren't saving anything until the final month...so that interest is deflated. If you want to claim you're saving (I'll make up a number here) $20,000 in interest, then you should discount that back using a PV (present value) formula. Let me give an example to make more sense of this...

Let's say I have a contest whereby I say I'm raffling off $1M. Each person buys a ticket for $1,000, and I'll sell 1,000 tickets. You might think..."well gee, how's he going to make any money doing that...he's collecting $1M, and paying back out $1M". But in the fine print it says that the $1M prize will be paid 5 years from now. I then get to use/invest the money for 5 years, and simply pay the prize at that time...what a deal! Imagine if it was 30 years instead of 5 years! This is exactly what the lottery does in some states....the cash prize is actually typically an annuity paid over many years....and if you want the money in a lump sum now...you get a MUCH smaller amount.

 

[pb4uski]

....Anyway, so this is all very good. This means that going for a 30 year will probably allow the flexibility I want w/o being locked into an early payoff. Now, just need to find a house to buy... thanks all for the assistance!

The trade-off of 15 year vs 30 year is that the 15 year interest rate is lower so your interest cost over the life of the loan is lower all else being equal but the 15 year payment is higher and if you run into financial difficulties you still must make the higher payment to avoid default.

If the 15 year payments are comfortable for you but you are worried about the lack of flexibility, you can do a 30 year loan and make the payments on a 15 year loan and your term would be just a bit over 15 years.

For example, let's say your choice is between a 15 year loan at 3.75% or a 30 year loan at 4.00% and you are borrowing $100k, then your monthly payment would be 727.22 a month for the 15 year loan or 477.42 a month for the 30 year loan. However, let's say you take the 30 year loan but pay 727.22 a month - the loan would be paid off in less than 15 1/2 years but if during that 15 1/2 years something blew up and paying 727 a month became a burden you would only have to pay 477 to keep the loan current.

 

[rescueme]

Wow, congrats on the aggressive paydown! And thanks for the tip.

Well, I had some help. We had just built our home (first one we built, but the forth we had along the journey) and had the specs drawn up to make it our retirement home with a lot of things added for the long term.

While DW never contributed to any expenses (yes, including the note/mortgage) over the years (we always planned to live on only my income - "just in case") she wanted to ensure we entered retirement debt free (see my "rock"). To that end, her contributions, along with my higher principal only payments allowed us to pay off our debt many years earlier than that. As I remember from long gone spreadsheets, we had a bit over $125k in "foregone interest" - IOW money we did not have to put out for that original 30-year term.

An additional note; we made the final payment in late 1999. At that time, we redirected my payments to the equity market. If you remember what happened 2000-02, we were able to buy very cheap and wound up to be able to "cash in" our profits, which lead to our planned ER in 2007 (I did, she didn't - not emotionally ready).

Sometimes you can't beat a bit of planning - along with dumb luck...

 

[Finance Dave]

Here's a website with a calculator.

http://www.amortization-calc.com/

Try the following:
$100,000 loan
30 years
4% interest
show by month

If you paid an extra $144.56 in month 1 only one time (note this is the principal amount in month 2), you would save $332.85 (this is the interest in month 2), but not until the end of the loan period...30 years later.

$332.85 won't be worth nearly as much in 30 years as it is today. Don't get me wrong...I'm still in favor of paying off early...I just always see these articles saying how you can save hundreds of thousands of dollars by paying off your loan early...yet they fail to mention TVM (time value of money).

 

[pb4uski]

Here's a website with a calculator.

Amortization Schedule Calculator

Try the following:
$100,000 loan
30 years
4% interest
show by month

If you paid an extra $144.56 in month 1 only one time (note this is the principal amount in month 2), you would save $332.85 (this is the interest in month 2), but not until the end of the loan period...30 years later.

$332.85 won't be worth nearly as much in 30 years as it is today. Don't get me wrong...I'm still in favor of paying off early...I just always see these articles saying how you can save hundreds of thousands of dollars by paying off your loan early...yet they fail to mention TVM (time value of money).

True, but few loans last their entire 30 year term. I've had 7 mortgages over the years and none has lasted its full term.

 

[Finance Dave]

True, but few loans last their entire 30 year term. I've had 7 mortgages over the years and none has lasted its full term.

The concept still applies...if you keep it 8 years, then that amount should be discounted for 8 years, etc.

 

[catccc]

I don't see anyone saying you're "correct"...he just said that's the way he did it.

I agree with p4buski. It's not that they "recalculate" anything, but it will come off the principal balance regardless of how you do it.

The one clarification is that yes, you do avoid the interest when you pay additional principal...but it's a bit misleading. You are saving future interest.

For example, let's say you pay additional in the very first month of your 30-year loan, and don't pay any more additional after that. Then your final payment, 359 payments later, would be smaller (or perhaps zero, depending on how much additional you paid). You really aren't saving anything until the final month...so that interest is deflated. If you want to claim you're saving (I'll make up a number here) $20,000 in interest, then you should discount that back using a PV (present value) formula. Let me give an example to make more sense of this...

Let's say I have a contest whereby I say I'm raffling off $1M. Each person buys a ticket for $1,000, and I'll sell 1,000 tickets. You might think..."well gee, how's he going to make any money doing that...he's collecting $1M, and paying back out $1M". But in the fine print it says that the $1M prize will be paid 5 years from now. I then get to use/invest the money for 5 years, and simply pay the prize at that time...what a deal! Imagine if it was 30 years instead of 5 years! This is exactly what the lottery does in some states....the cash prize is actually typically an annuity paid over many years....and if you want the money in a lump sum now...you get a MUCH smaller amount.

1. yeah, I misread a post... nobody said I was correct. BUT

2. YES! I think you understand my question. My question is about saving future interest, and about not saving anything until the final month. (Unless I'm misunderstanding you. It seems I've been having my fair share of misunderstanding lately.) Okay so instead of asking my question in words, I'll ask it in numbers:

So let's say there's a 100K loan for 30 years at 3%. If you run an amortization schedule, it would say the payment is $421.60.

The 1st month's payment is $250 interest and $171.60 principal. So you pay $421.60. The next month, the payment is of course the same $421.60, but this time it is $249.57 interest and $171.03 principal. That's scenario 1, you just pay the same $421.60 each month and do not pay any extra towards principal. The principal and interest breakout for each payment will follow the original amortization schedule.

Okay, scenario 2: Now let's say instead of paying 421.60 in month 1, you also have them apply another $5,000.00 to the principal as well. In the second month, you pay just the 421.60. HERE IS MY QUESTION. Is the 2nd month payment of 421.60:

A) now 237.07 interest and $184.53 principal because of the extra 5K you paid? Or

B) it is the same $249.57 interest and $171.03 as in scenario 1, because the original amortization schedule dictates the interest/principal breakout?

I think everyone here is telling me it would be the 237.07 interest and $184.53 principal. The bank rep was telling me it be the same old $249.57 interest and $171.03 principal that the original schedule had called for. I of course want the answer to be A....

 

[Finance Dave]

1. yeah, I misread a post... nobody said I was correct. BUT

2. YES! I think you understand my question. My question is about saving future interest, and about not saving anything until the final month. (Unless I'm misunderstanding you. It seems I've been having my fair share of misunderstanding lately.) Okay so instead of asking my question in words, I'll ask it in numbers:

So let's say there's a 100K loan for 30 years at 3%. If you run an amortization schedule, it would say the payment is $421.60.

The 1st month's payment is $250 interest and $171.60 principal. So you pay $421.60. The next month, the payment is of course the same $421.60, but this time it is $249.57 interest and $171.03 principal. That's scenario 1, you just pay the same $421.60 each month and do not pay any extra towards principal. The principal and interest breakout for each payment will follow the original amortization schedule.

Okay, scenario 2: Now let's say instead of paying 421.60 in month 1, you also have them apply another $5,000.00 to the principal as well. In the second month, you pay just the 421.60. HERE IS MY QUESTION. Is the 2nd month payment of 421.60:

A) now 237.07 interest and $184.53 principal because of the extra 5K you paid? Or

B) it is the same $249.57 interest and $171.03 as in scenario 1, because the original amortization schedule dictates the interest/principal breakout?

I think everyone here is telling me it would be the 237.07 interest and $184.53 principal. The bank rep was telling me it be the same old $249.57 interest and $171.03 principal that the original schedule had called for. I of course want the answer to be A....

Answer is B. But you can take the $5,000, and "exhaust" all future months' principal (starting in month 3), until you run out of the $5,000...and that will tell you how many months you just took off your loan by paying the additional $5,000. My guess is that it will be significant.

 

[Gill]

The bank rep doesn't know what they're talking about. When the principal is reduced they're required by law to reduce the amount on which the interest is calculated. To do otherwise would be charging more interest than the note allows.
Bruce

 

[meierlde]

The bank rep doesn't know what they're talking about. When the principal is reduced they're required by law to reduce the amount on which the interest is calculated. To do otherwise would be charging more interest than the note allows.
Bruce

Yes mortages charge basically simple interest. A car loan is very different and uses the rule of 72 if paid off early. basically if you have the original amotization table and make a partial prepayment, you can go the the table until the principal is closest and get an idea of the number of months shaved off. (Note that this really works best in the first 10 years of a mortgage) After 20 years the payment is now 1/2 principal and 1/2 interest.

 

[MissMolly]

I'm sorry Finance Dave, but I have to disagree with you. The answer would be A. I worked 30+ years in the mortgage servicing industry. If extra money is paid towards the principal in any given month, then the principal/interest split on the following month's payment will be different than the original amortization schedule. The interest amout due is indeed recalculated each month based on the amount of remaining principal.

 

[DJRR]

Answer is B. But you can take the $5,000, and "exhaust" all future months' principal (starting in month 3), until you run out of the $5,000...and that will tell you how many months you just took off your loan by paying the additional $5,000. My guess is that it will be significant.

This is wrong. It is simple interest. You save the interest each month. You do not have to wait until the last payment, neither do you get it all at once. These are, apparently, both common misconceptions .

The term is shorter because you pay less interest. The reason is because your pay less interest EACH month because your principal balance is lower.

Maybe it is easier to think of it as a non-amortizing interest only loan. If you owe 1,000 and the interest is 12% you pay $10 per month. If you "prepay" $500 then you only pay $5 per month. You have saved interest, but your term is exactly the same - indefinite.

Amortization works the same way, except since there is a term that is shortened.

You cannot "invest" or realize the money until the mortgage is paid off or the term expires because you have invested it in your mortgage, hence the liquidity problem, but you do "save" the interest the same as if you bought an investment with the equivalent term and yield.

Edited it to add that if you tried to base your taxes interest deduction on B you would be getting a visit from your friendly IRS agent

 

[catccc]

Thanks again everyone. I can't believe one bank rep I spoke to once 3-4 years ago has caused all this. I'm not really a total financial dummy. I actually did pass the CPA exam and deal with amortization schedules all the time. I just believed this one guy that told me mortgages were different.

Finance Dave, pretty much everyone says that the answer is A. (Which is what I always assumed until I was told otherwise by said bank rep...) So, I'm curious, why do you believe otherwise? Did you talk to the same guy I did, lol?!

 

[catccc]

Okay, now that we are all (mostly) on the same page... Which situation is the norm for mortgages, daily or monthly interest accrual?

 

[MissMolly]

Okay, now that we are all (mostly) on the same page... Which situation is the norm for mortgages, daily or monthly interest accrual?

Monthly. It doesn't matter if you pay your payment on the 1st of the month or the 30th - interest will be exactly the same (but watch out for those late charges )

 

[Nords]

Okay, so I have one Yes, I'm correct, and one No, you are not.
I should clarify to pb4uski that I understand that typically, loans are recalculated and the interest changes when the principal does.
But I am asking about home mortgages specifically, which I was told by a bank rep typically do not recalculate for lowered principal unless there is specific language stating such recalculations, or if you "recast" the mortgage. Meaning the interest owed is set in stone until the loan is ended by complete repayment. I understand how amortization schedules work, I just was told that the bank will not repeatedly "throw out" the old schedule and make up a new one to accomodate for your additional principal payments.
Anyone else care to weigh in? If you can confirm or deny my understanding, can you let me know how you know? (i.e. "that is how my mortgage seemed to work" weighs less heavily than "I've been a mortgage loan officer for 15 years.") At any rate, I do appreciate all responses.

Math by majority vote. Interesting. I wish that tactic could change the result of the calculation.

I wonder whether the bank staff have any financial interest in helping you make a decision. It's like asking a surgeon if you need surgery. It's like handing your credit card to the car dealer to find out how much payment you can afford. It's like asking a housepainter if your house... well... you get the point.

I don't know about you guys, but even BofA (arguably one of the most incompetent mortgage processors I've ever seen) manages to spit out an annual statement telling me how much principal and how much interest I've paid each year. If I pay more principal than required by the mortgage payment, then the very next month the principal balance is reduced by the amount of the excess payment. They also tell you on the 1099 how much interest you've paid, and if you're paying down the balance early then you're going to pay less interest than forecast by the amortization schedule.

Maybe there's a confusion over terminology. The bank is unlikely to change the interest rate of the loan (it'll stay fixed at 4% for 30 years or whatever) but the dollar amount of the interest paid will change each month as the remaining principal balance drops. I may be making the same vocabulary mistake, but I think "recast" refers to changing the interest rate of the loan-- not the dollar amount of interest paid.

So if you pay more principal one month, the bank's computer will automatically note that (assuming the bank staff process it correctly) and the following month a little more of your payment will go to principal than forecast by the old amortization schedule. On the mortgage and the closing documents it'll say something like "no penalty or fee for early payment". But I doubt you'll see a detailed description of the process by which the bank computer calculates the amortization of a loan with prepayments.

I'm sure it depends on the mortgage, but generally speaking, am I understanding this correctly?
So I guess if you want to pay off your mortgage early, it is better to put the extra you'd put towards the principal someplace else safe (savings account) and then once your savings account balance is equal to the remaining principal on the mortgage, and then completely payoff/end the loan at that time?

You could do that if you wanted to. It certainly gives you more liquidity and more choices.

However it's highly likely that your savings account is paying 0.5%-1%/year while your mortgage is costing you 3-4%/year. In other words you're losing money by stashing your money in a savings account instead of prepaying the mortgage. That's your cost of keeping your opportunities open.

 

[MissMolly]

Math by majority vote. Interesting. I wish that tactic could change the result of the calculation.

I wonder whether the bank staff have any financial interest in helping you make a decision. It's like asking a surgeon if you need surgery. It's like handing your credit card to the car dealer to find out how much payment you can afford. It's like asking a housepainter if your house... well... you get the point.

I don't know about you guys, but even BofA (arguably one of the most incompetent mortgage processors I've ever seen) manages to spit out an annual statement telling me how much principal and how much interest I've paid each year. If I pay more principal than required by the mortgage payment, then the very next month the principal balance is reduced by the amount of the excess payment. They also tell you on the 1099 how much interest you've paid, and if you're paying down the balance early then you're going to pay less interest than forecast by the amortization schedule.

Maybe there's a confusion over terminology. The bank is unlikely to change the interest rate of the loan (it'll stay fixed at 4% for 30 years or whatever) but the dollar amount of the interest paid will change each month as the remaining principal balance drops. I may be making the same vocabulary mistake, but I think "recast" refers to changing the interest rate of the loan-- not the dollar amount of interest paid.

So if you pay more principal one month, the bank's computer will automatically note that (assuming the bank staff process it correctly) and the following month a little more of your payment will go to principal than forecast by the old amortization schedule. On the mortgage and the closing documents it'll say something like "no penalty or fee for early payment". But I doubt you'll see a detailed description of the process by which the bank computer calculates the amortization of a loan with prepayments.


You could do that if you wanted to. It certainly gives you more liquidity and more choices.

However it's highly likely that your savings account is paying 0.5%-1%/year while your mortgage is costing you 3-4%/year. In other words you're losing money by stashing your money in a savings account instead of prepaying the mortgage. That's your cost of keeping your opportunities open.

Recasting can also mean changing the term of the mortgage without any change to the interest rate. Assuming the change in term is to lengthen the maturity date, and keeping the interest rate the same, the remaining unpaid balance woud be reamortized over the new, extended term and would result in lower monthly payments.

 

[catccc]

Math by majority vote. Interesting. I wish that tactic could change the result of the calculation.

I wonder whether the bank staff have any financial interest in helping you make a decision. It's like asking a surgeon if you need surgery. It's like handing your credit card to the car dealer to find out how much payment you can afford. It's like asking a housepainter if your house... well... you get the point.

I don't know about you guys, but even BofA (arguably one of the most incompetent mortgage processors I've ever seen) manages to spit out an annual statement telling me how much principal and how much interest I've paid each year. If I pay more principal than required by the mortgage payment, then the very next month the principal balance is reduced by the amount of the excess payment. They also tell you on the 1099 how much interest you've paid, and if you're paying down the balance early then you're going to pay less interest than forecast by the amortization schedule.

Maybe there's a confusion over terminology. The bank is unlikely to change the interest rate of the loan (it'll stay fixed at 4% for 30 years or whatever) but the dollar amount of the interest paid will change each month as the remaining principal balance drops. I may be making the same vocabulary mistake, but I think "recast" refers to changing the interest rate of the loan-- not the dollar amount of interest paid.

So if you pay more principal one month, the bank's computer will automatically note that (assuming the bank staff process it correctly) and the following month a little more of your payment will go to principal than forecast by the old amortization schedule. On the mortgage and the closing documents it'll say something like "no penalty or fee for early payment". But I doubt you'll see a detailed description of the process by which the bank computer calculates the amortization of a loan with prepayments.


You could do that if you wanted to. It certainly gives you more liquidity and more choices.

However it's highly likely that your savings account is paying 0.5%-1%/year while your mortgage is costing you 3-4%/year. In other words you're losing money by stashing your money in a savings account instead of prepaying the mortgage. That's your cost of keeping your opportunities open.

1. Well, if the bank rep was trying to get more $$ out of me, he would have preferred to tell me the truth, which is that the interest recalculates, because if it didn't, I'd choose a 15 yr over a 30 yr, resulting in less interest income to the bank. I think he just plain old didn't know how it worked and told me the wrong thing. I even remember him remarking "Oh, no, the interest won't change, the bank is expecting to collect a certain amount each month until the loan is paid off, whether it's early or on time." Coincidentally, it very well may have been BoA I was speaking with...

2. I was all set on a 15 yr mortgage, just because I really wanted the emotional freedom of knowing in 15 years I'd be done. But someone pointed out with rates as low as they are, I could be "laughing all the way to the bank" with CDs that pay 5-6% in future years. So getting a 30 year would allow me to put excess cash into the mortgage (because I cannot find a safe 3% right now) and possibly changing my tune as rates rise. I remember my savings account paying 5-6% in 2006 or so. It wasn't all that long ago, I could see it coming back. And if not, than I'd just keep plugging away at the mortgage, assuming the status of emergency funds was fine and retirement contributions were still maxed. I'm pretty risk averse and wouldn't need cash beyond an appropriate emergency fund for "opportunities."

 

[catccc]

Recasting can also mean changing the term of the mortgage without any change to the interest rate. Assuming the change in term is to lengthen the maturity date, and keeping the interest rate the same, the remaining unpaid balance woud be reamortized over the new, extended term and would result in lower monthly payments.

So nobody ever recasts to shorten a loan life because that is inherent to the way a regular mortgage works, right?

 

[MissMolly]

So nobody ever recasts to shorten a loan life because that is inherent to the way a regular mortgage works, right?

Not in my exerience, but that is not to say it's hasn't been done. Besides, if you want to shorten the life of a mortgage, simply make extra payments to principal. No point in going through all the paperwork when you can accomplish the same thing with the extra payments.

What used to be called "recasting" is now what is referred to as a loan modification.

 

[mathjak107]

actually the best deal around would have been 5 year adjustables since most folks move every 5-7 years or refinance.

for now things may have slowed down but only because of conditions dictating that we may have to stay put longer. but thats not what we would be doing if we could sell or refinance.