Early payoff of mortgages: does the interest get recalculated?

Question

I understand that a monthly payment of a mortgage consists of principal and interest. At the beginning of a mortgage, most of the monthly payment goes towards the interest and only a small part towards the principal.

Now, assume I want to close the mortgage early. What happens then to the monthly payments already paid? Do they get recalculated because the interest on those should have been less?

In the corner case of paying back a 30 years loan after 1 year, most of my 12 monthly payments went towards an interest calculated based on 30 years, but now I'm paying it back much earlier. Would the drop in the interest be applied retrospectively or basically all those payments are lost?

Answer 1

What happens then to the monthly payments already paid? Do they get recalculated because the interest on those should have been less?

No - interest is calculated on the remaining principal.

The interest rate does not change over the life of the loan (assuming a fixed rate mortgage or the initial fixed period of an ARM), but the amount of interest decreases as you pay down principal.

If you make an additional payment, the interest rate does not change, but your remaining principal will be less that what the original amortization schedule indicated so your future payment will include less interest (and more principal).

If you pay off the loan completely, then you pay no more interest (because there is no more principal).

Would the drop in the interest be applied retrospectively or basically all those payments are lost?

Nothing is "lost". You paid interest on the remaining principal at the time of those payments, and will pay less interest (amount, not rate) going forward because your principal will be lower.

Answer 2

Don't think of a mortgage as some 'black box calculation' where the amount of interest each year is unknowable. A mortgage amortization schedule is simply the amount of payments required to meet 3 conditions: (a) the total balance is repaid at the end of the mortgage; (b) interest is charged based on the balance remaining every month; and (c) the payment amount is the same every month. If you look at some examples with actual numbers, it may get quite a bit more clear:

Assume you borrow a 100k mortgage, that will last for 30 years. If there was no interest, your monthly payment would be 100,000 / (30*12 months) = $277.78. Now let's keep the monthly payment the same, but add on 3% interest per year. In the first month, your interest would be based on a $100,000 balance * 3% / 12 months [I am ignoring compounding issues for simplicity]. So your interest would be $3,000 / 12 = $250. So because you made a $277.78 payment, the first $250 would go against interest, and the final $27.78 would go against principal. In month 2, your interest would be $99,972.22 remaining balance * 3% / 12 months = $249.93. So in that next month's payment, the interest cost has decreased by $.07, and that extra 7 cents has gone towards your principal payment.

Now you may be thinking "Wow, I'll never pay off my mortgage if that little goes towards principal!". And you'd be almost right. With those mortgage terms, it would take you about 77 years to repay!

So in order to ensure that you can pay the full amount of the mortgage within the expected time frame, the bank calculates what your total, all-in payment would need to be, in order to get the balance to zero, including anticipated interest. In this case, that amount would be about $420 - you can use this mortgage calculator [no affiliation] to check: https://www.usbank.com/home-loans/mortgage/mortgage-calculators.html.

Once you know the payment amount, you can easily calculate by hand how much interest you are charged each period, and how much principal you are paying. Assuming the rates in the example above, the interest amount of $250 for the first month still applies, but because your payment would be about $420, you would pay about $170 to reduce the principal owing. The next month, your outstanding principal balance would be $99,830, and the interest the next month would be about $249.57. This is the key point: the bank charges you interest based on the balance outstanding each month, not based on the total hypothetical amount of the mortgage.

Some mortgages may charge you a penalty for prepayment, though often there is some amount of prepayment allowed penalty free by law, depending on your jurisdiction. But apart from that possible penalty [which you should ask your mortgage broker about and read in your contract], the calculation of interest on the mortgage itself would not change based on paying faster than the amortization schedule.

Answer 3

Paying back a mortgage early does not reduce the interest rate. It reduces the interest payments because you pay the interest for less long, but it does not reduce the rate.

Let's say for the sake of simplicity that you take out a mortgage of $100000 at 12% over 25 years. You are initially being charged $12000 in interest per year, or $1000 per month. Let's say your payments are $1300.

At the start you are paying $1000 in interest per month. $300 of each payment is reducing the loan amount (principal).

Let's say you pay back the loan after making one payment. Your loan amount has reduced to $99700, so if you pay that you can pay off the loan. You don't get the $1000 back - that's the interest you paid to have the loan for a month. Your interest rate doesn't get recalculated - you pay approximately 1% of the amount you have outstanding on the loan each month.

In reality it is more complicated than that, and there are fees involved in early repayment. But that's the principle. Also all my numbers are approximate. 12% per year doesn't equate to exactly 1% per month for various reasons that are not important to the example.

Answer 4

Now, assume I want to close the mortgage early. What happens then to the monthly payments already paid? Do they get recalculated because the interest on those should have been less?

In the corner case of paying back a 30 years loan after 1 year, most of my 12 monthly payments went towards an interest calculated based on 30 years, but now I'm paying it back much earlier. Would the drop in the interest be applied retrospectively or basically all those payments are lost?

I suspect you have a misconception about the way that mortgage interest works.

Suppose you have a 30-year mortgage for $300,000 and an interest rate of 4%. Let me punch that into my mortgage calculator here. In the first month, my calculator says you'll pay... $1,000 in interest.

All right, now suppose you want to save money on interest, so you still get a $300,000 loan at a 4% interest rate, but you make it a 10-year loan again. How much do you save on your monthly interest payment? Let me punch that into my calculator again. Your first month's interest payment is going to be... $1,000.

It's the same number! Changing the term of the loan doesn't change the interest payment at all.

Why is this? Well, the formula for interest on a mortgage is very simple: it's the balance, times the interest rate, divided by 12. The term of the mortgage doesn't come into the calculation at all.

But wait, won't a 10-year mortgage have a lot less interest on it than a 30-year mortgage? How can it be the same?

Well, one thing to notice is that for the first month, even though the amount of interest you pay is the same regardless of term, the percentage of interest is different. For the 30-year mortgage, your first payment is $1,432, and $1,000 of that is interest, which is 70% of the payment. For the 10-year mortgage, on the other hand, your first payment is $3,037, and $1,000 of that is interest, which is 33% of the payment. The percentage of interest is smaller not because the amount of interest is smaller, but because the total payment is larger.

The other thing to notice is that, since you make larger payments on a 10-year mortgage than on a 30-year mortgage, the balance goes down faster, and that makes the amount of interest go down faster, too. With the 10-year mortgage, your balance after 5 years is only $165,000, so you only have to pay $558 a month in interest. With the 30-year mortgage, on the other hand, your balance after 5 years is $271,000, meaning you have to pay $906 a month in interest.

In other words, you aren't paying less interest because the term of the loan is shorter; you're paying less interest because the balance is smaller.

So, to answer your specific questions:

Now, assume I want to close the mortgage early. What happens then to the monthly payments already paid? Do they get recalculated because the interest on those should have been less?

The interest on those shouldn't have been less; they should have been exactly what they were. So there's nothing to recalculate.

Would the drop in the interest be applied retrospectively or basically all those payments are lost?

The only thing that causes a "drop in the interest" is reducing the balance of the loan—in other words, paying principal. Since you're making extra payments today, not a year ago, the drop in the interest occurs today, not a year ago. There's nothing to apply retroactively.

The past payments aren't really "lost," though. You bought something with that money: namely, the privilege of living in a house that you owe money on. You've already used up the service that you paid for, and you're not going to get a refund for it.

Answer 5

The interest rate doesn't change, but how much you owe changes. This triggers a calculation in the per month amount of payment due for the interest portion of a loan.

For example, a typical payment might look like:

$1153 (payment) = $102 (principle) + $1051 (interest)

Where the interest is calculated by

$1051 (interest) = ( 8% (annual interest rate) * $157650 (remaining balance of the loan) ) / 12 (months)

Note that your $102 payment (the amount of the payment which applies to the loan) will barely adjust the $157650 loan to $157548.

When you pay above your $1153 payment, by (for example) paying $1400, a different scenario occurs. The payment is split into your regular payment and additional payment against the principle ($1153 + $247). This means your overall loan will decrease from $157650 to $157301 ($102 removed from the regular payment + $247 removed from the extra principle).

This means that now the next interest payment will be $1048.68 instead of $1050.32

$1048.68 (interest) = ( 8% (annual interest rate) * $157301 (remaining balance of the loan) ) / 12 (months)

instead of

$1050.32 (interest) = ( 8% (annual interest rate) * $157548 (remaining balance of the loan) ) / 12 (months) 

So the interest (as an absolute amount you'll have to pay over the rest of the loan) drops, but the interest rate doesn't drop. The rate is fixed at 8%.

When you see drops in payments, it's because the loan is for a fixed amount of time, and with the extra payments, there's no longer enough interest to keep the deadline fixed. So, the lender permits a lower pay-back rate, calculated to have the deadline remain fixed.

Note that even in my simple example, adjusting the payment from $1153 to $1400 was like getting a little more than 2 additional principle payments for the cost of an additional $247. If one didn't pay $1400, they'd have to pay for an additional 2 1/2 months to get about the same amount of principle ($247). The big difference is that they pay the $247 now, instead of paying the $2857 (2.5 * $1153) later.

Sometimes paying later is a good idea, but if you don't have a clear way of turning your (in my example) $247 into $2857 before the end of your loan, early loan pay back is a no-brains / no-luck investment strategy that often beats other investment strategies.