Mortgages: Interest Calculation/Recalculation

[catccc]

I'm sure it depends on the mortgage, but generally speaking, am I understanding this correctly?

If you put extra towards the principal, your loan will end early and you will save the interest that you would have paid in the last x years that you got out of by paying extra. But if you put extra towards the principal in one month, my understanding is that your next month's payment still has the same principal/interest breakout that it would have w/o the prior month's extra principal payment, because most mortgages do not recalculate interest on a regular basis. In order to save any interest on that next month's payment, you'd have to have the loan recast. Is my understanding correct?

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?

Any insight is greatly appreciated! I'm trying to decide between a 15 and 30 year loan. I want to pay it off early just to be done, but with rates so low, it may behoove me to have the option to take 30 years...

 

[Texas Proud]

From everything that I have seen with mortgages, your thinking is not correct.

 

[pb4uski]

Your understanding of how interest and principal reductions are determined is not correct.

For each month, the bank will calculate the interest as the principal balance times the annual interest rate times time, typically 30/360. So if your principal balance at the beginning of the month is $50,000 and your interest rate is 4% then the interest would be $166.67 ($50,000 * 4% * 30/360). The principal reduction relating to that payment will be the payment made less the interest for that month.

If you make an additional principal payment, it throws the whole original amortization schedule out the window. The next month's interest will be lower than according to the original schedule and the principal will be higher and this will continue on and on until the principal balance is zero.

Assuming that your mortgage rate exceeds what that "safe" savings account pays you would be much better off making extra principal payments on the mortgage than saving on the side until the savings account is equal to your remaining principal balance.

 

[donheff]

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?

I see that others are debunking your interest issue but the above is what I did on both houses. While DW and I were working the interest deduction was pretty valuable and slowly cutting it down seemed questionable. We mentally earmarked a portion of our savings for paying off the mortgages around the time I would retire. that way the funds were available to us if needed in the meantime. When the time came we simply paid off several hundred thousand in loans and became debt free.

 

[catccc]

Your understanding of how interest and principal reductions are determined is not correct.

For each month, the bank will calculate the interest as the principal balance times the annual interest rate times time, typically 30/360. So if your principal balance at the beginning of the month is $50,000 and your interest rate is 4% then the interest would be $166.67 ($50,000 * 4% * 30/360). The principal reduction relating to that payment will be the payment made less the interest for that month.

If you make an additional principal payment, it throws the whole original amortization schedule out the window. The next month's interest will be lower than according to the original schedule and the principal will be higher and this will continue on and on until the principal balance is zero.

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.

 

[photoguy]

On my mortgage statement from my credit union it breaks out how much of each payment goes to principal versus interest. Every month the amount of interest paid drops a little as we are paying down principal. It also adjusts properly when I pay extra on the principal.

Any insight is greatly appreciated! I'm trying to decide between a 15 and 30 year loan. I want to pay it off early just to be done, but with rates so low, it may behoove me to have the option to take 30 years...

I would take whichever option gives you the lowest interest rate. If they are similar, the 30 year gives you more flexibility. You can still pay off your loan in 15 years by making additional payments.

 

[rbmrtn]

There is a calculator at bankrate you can play with

Amortization Schedule Calculator -- Bankrate.com

 

[catccc]

On my mortgage statement from my credit union it breaks out how much of each payment goes to principal versus interest. Every month the amount of interest paid drops a little as we are paying down principal. It also adjusts properly when I pay extra on the principal.

I would take whichever option gives you the lowest interest rate. If they are similar, the 30 year gives you more flexibility. You can still pay off your loan in 15 years by making additional payments.

Thanks for your input! So do you independently calculate what your interest should be after an extra principal payment, and the credit union concurs with your numbers? Do you know if there is any terminology to ask for this kind of treatment for a mortgage, or if this was atypical when you were looking for a mortgage?

 

[photoguy]

I haven't bothered to recalculate the interest remaining and double check against the credit union's computation. But qualitatively the numbers roughly match my expectations. E.g., if a regular payment reduces $3 from monthly interest, a payment with twice the principal reduction lowers the next month's interest by about $6.

I believe this is typical but I've only had the one house with a few refinances. I made sure I had no prepayment penalty (I'd make this a mandatory requirement).

 

[catccc]

There is a calculator at bankrate you can play with

Amortization Schedule Calculator -- Bankrate.com

Thanks, but it looks like this calculator makes the assumption that your lender recalculates interest regularly, which may not be the case. (?)

 

[pb4uski]

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.

The response that I provided was for home mortgages specifically (as well as most other loans). Your bank rep either misunderstood your question or is misinformed. Interest is not set in stone but is a function of principal balance, rate and time. All mortgages that I have ever had work that way and I once ran a mortgage servicing unit and all our residential mortgages worked that way.

Also see http://homeguides.sfgate.com/paying-down-mortgage-work-7676.html

 

[REWahoo]

Your bank rep either misunderstood your question or is misinformed. Interest is not set in stone but is a function of principal balance, rate and time.

+1

 

[Tyro]

I would read the mortgage document itself as to if or how prepayment is recalculated. I might call the "bank", however if the mortgage has been sold or assigned, the assignee may not know the language of the mortgage themselves.

Tyro

 

[catccc]

The response that I provided was for home mortgages specifically (as well as most other loans). Your bank rep either misunderstood your question or is misinformed. Interest is not set in stone but is a function of principal balance, rate and time. All mortgages that I have ever had work that way and I once ran a mortgage servicing unit and all our residential mortgages worked that way.

Also see How Does Paying Down a Mortgage Work? | Home Guides | SF Gate

Thanks! It seems like it's about 1/2 and 1/2 (recalc or not recalc) on what the situation is among colleagues/friends' mortgages, assuming they understand correctly how their mortgages work. I suppose I will just have to comb thru the terms quite finely to see exactly what the deal is if/when I am getting a loan.

 

[Gotadimple]

Thanks, but it looks like this calculator makes the assumption that your lender recalculates interest regularly, which may not be the case. (?)

If the bank's lending officer is telling you that interest payments are firm unless the mortgage is recast, then I'd ask him/her to show you the language in the loan contract.

Secondly, I'd ask about pre-payment penalties. If they don't adjust for extra principle payments, what would they do to you in an early payoff?

Then, I'd ask what incentive the bank will give you to accept such a restriction in your note. The point being, that you can take the loan elsewhere. All of this assumes the rate being quoted is competitive.

-- Rita

 

[catccc]

I would take whichever option gives you the lowest interest rate. If they are similar, the 30 year gives you more flexibility. You can still pay off your loan in 15 years by making additional payments.

True, but if the 30 yr doesn't recalc interest for extra principal payments, than assuming the same rate of interest for a 15 yr and a 30 year, you'll save more by getting the 15 and paying in 15 over getting the 30 and paying in 15...

 

[Gotadimple]

And to add to my earlier post, ask:

If the bank holds the loan or if they sell it. If they sell it to the government, they have to use standard language in their contracts. This doesn't sound like the 'standard.'

 

[REWahoo]

This doesn't sound like the 'standard.'

+1

OP, care to name the bank/mortgage company?

 

[Texas Proud]

The response that I provided was for home mortgages specifically (as well as most other loans). Your bank rep either misunderstood your question or is misinformed. Interest is not set in stone but is a function of principal balance, rate and time. All mortgages that I have ever had work that way and I once ran a mortgage servicing unit and all our residential mortgages worked that way.

Also see How Does Paying Down a Mortgage Work? | Home Guides | SF Gate

And at one time I was a trustee on MBS and all the servicers that I dealt with did the same...

I also do not see anybody that said you were correct.... they said they did what you were thinking about putting the money aside and paying it off when they had enough... not that the calculation of interest was what you thought.... just saying....

 

[rbmrtn]

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.

Here's another article from bankrate

Supersaver does not need mortgage recast

 

[DJRR]

Thanks! It seems like it's about 1/2 and 1/2 (recalc or not recalc) on what the situation is among colleagues/friends' mortgages, assuming they understand correctly how their mortgages work. I suppose I will just have to comb thru the terms quite finely to see exactly what the deal is if/when I am getting a loan.

It is not half and half. Since 90% of all mortgages are FNMA, FHLMC or FHA it is doubtful any work differently. I have never seen one.

You are confusing two things.

1. The monthly payment - This never changes on a fixed rate mortgage unless you "recast" the loan.

2. The monthly amount applied to interest - This changes every month depending on the amount of principal remaining.

To make it simple. If your monthly payment is 1,000 and you pay 800 interest and 200 to principal and you prepay a big chunk your next month payment will be 1,000 but it will be 600 interest and 400 principal.

Your original loan was 360 payments, so now you will owe fewer payments because it will amortize earlier. Your savings are realized immediately as you pay less interest the next month. You do not have to wait.

You will lose the liquidity, which is why some recommend to keep the money in a savings account until you are ready to pay it off. If you do this your interest savings will be less, but you will have the money if you need it for something instead of the bank having it.

If you want a lower monthly payment the only way to get one is to refinance or recast the mortgage.

Hope that is clear.

 

[catccc]

I also do not see anybody that said you were correct....

Okay, I think I actually misread your short post and thought you were concurring. Whoops, sorry about that! I just rounded up a few co-workers (2 are CPAs, you'd think they'd know how their own mortgages work...) who all told me their mortgages do not recalc. So strange that I get such a variety of responses on this.

 

[catccc]

okay, seems the consensus here is that my understanding is wrong. (And of course for my sake, I hope it is...) It really was based all on that one bank rep/lender's statement, followed by anecdotal details from others. I like to think that the population on these forums is better versed in these kind of details than the general population. Like I said, I'll just be really aware of the language if/when the time comes that I'm signing those loan docs.

 

[ChiliPepr]

who all told me their mortgages do not recalc. So strange that I get such a variety of responses on this.

I think you are confusing two things.... When you pay extra principal one month, the next month your principal/interest ratio of your mortgage payment will adjust (interest goes down, principal goes up) but your PAYMENT stays the same. Your monthly payment would not change unless you recast your mortgage.

For example, if you pay $1000 extra on your mortgage this month, your principal portion of next month's payment would be higher (and interest lower). And your mortgage would be payed off in less time. If you then recast your mortgage, the bank would take the amount you currently owe and figure out a lower monthly payment that would have you finish paying off your mortgage at your original payoff date (same time as your original note, but with lower payments).

Most companies will let you recast your mortgage only once, with a fee.

 

[Texas Proud]

okay, seems the consensus here is that my understanding is wrong. (And of course for my sake, I hope it is...) It really was based all on that one bank rep/lender's statement, followed by anecdotal details from others. I like to think that the population on these forums is better versed in these kind of details than the general population. Like I said, I'll just be really aware of the language if/when the time comes that I'm signing those loan docs.

I think DJRR's explanation is the best so far on possibly the confusion.... and the answer...