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Will a Big Check Reduce Future Payments? Depends on Your Loan.

By Jack Guttentag
Saturday, December 22, 2007

Many borrowers would like a mortgage in which the monthly payment drops after a large payment to principal. They may have irregular income, or they may anticipate coming into a large sum of money from a bonus, bequest or insurance settlement.

Mortgages fall into four categories with regard to how responsive they are to this need. Standard fixed-rate mortgages are the least responsive. Next come standard adjustable-rate mortgages; then any fixed-rate or adjustable-rate mortgage with an interest-only option; and finally CMG Financial's Home Ownership Accelerator mortgage, which is the most responsive.

  • Fixed-rate mortgages: Extra payments on a fixed-rate mortgage shorten the payoff period but do not affect the monthly payment.

    For example, if you borrow $100,000 for 30 years at 6 percent, your fully amortizing payment is $599.56. Pay this amount every month, and you pay off the loan in 30 years (360 months). If you make an extra payment of $10,000 in month two, your payment in all subsequent months remains $599.56. Your loan will pay off in month 280, 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. In the previous example, the payment could be dropped to $539.48, the fully amortizing payment that will pay off the loan over the original 30 years.

  • Adjustable-rate mortgages: With an ARM on which the borrower is making the fully amortizing payment, extra payments do change the monthly payment but not until the next rate adjustment. At that point, the payment is recalculated using the reduced balance and the original term.

    Assume that the $100,000, 6 percent loan is a three-year ARM and that an extra payment of $10,000 is made in month two. The payment would remain at $599.56 through month 36. In month 37, assuming that the rate stays at 6 percent, the payment would drop to $525.62. That is the new fully amortizing payment over the original term.

    On ARMs with longer initial rate periods, the drop in payment after an extra payment would be further delayed. On the popular five-year ARM, for example, the payment wouldn't drop until month 61.

    ARMs become more responsive after the initial rate period ends because rate and payment adjustments then occur more frequently -- in most cases, every year or every 6 months.

  • Mortgages with an interest-only option: If a loan is interest-only, the payment should decline in the month after an extra payment, whether the loan rate is fixed or adjustable. The interest-only payment on the $100,000 loan at 6 percent is $500. After the payment of $10,000 in month two, the interest-only payment should drop to $450 in month three.

    However, this doesn't always work because not all servicing systems can handle it properly. In some cases, the new payment is properly calculated but the borrower isn't told the new amount. In other cases, the payment adjustment is delayed -- sometimes for a year, sometimes for longer.

    Of course, if the loan is an ARM, the payment will adjust when the rate adjusts. If it is fixed-rate, however, the payment may not change until the end of the interest-only period, which could be five or 10 years.

    Whether the mortgage rate is fixed or adjustable, after the end of the interest-only period, payment responsiveness disappears. After that, it is like any other fixed- or adjustable-rate loan.

    If you are considering an interest-only loan and want immediate payment adjustments in response to extra payments, ask about it. Don't expect the loan officer or mortgage broker to volunteer that information. They are not involved in loan servicing, and chances are they will have to ask.

  • Home Ownership Accelerator: The most responsive type of mortgage is the Home Ownership Accelerator, because it has no required payment, only a maximum balance. As long as the balance is lower than the maximum, the borrower need make no payment at all.

    Accelerator borrowers who make lump-sum payments to reduce the balance and want to reduce payments to the fully amortizing level can just do it. The Accelerator servicer will not tell them the new payment. I am told that this will be remedied at some point.

    Until then, it is easy to calculate the payment using the fixed-rate-mortgage calculator on my Web site, http://www.mtgprofessor.com (7a on my Mortgage Calculator page). The Accelerator mortgage is an ARM that adjusts monthly, the fully amortizing payment changing a little every month, so borrowers who want to stay on track ought to repeat the exercise periodically.

    Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,http://www.mtgprofessor.com.

    Copyright 2007 Jack Guttentag

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