8

My friend was told by her bank she could not make early payments and apply them to the principal on her home mortgage. She wants to pay half her mortgage every two weeks and it seemed like a reasonable request.

She then asked what would happen if she just paid an extra lump sum once a year and asked it to be directed towards the principal. They told her they would only apply half to the principal and the other half to interest.

Are there any known laws explicitly allowing or preventing this behavior?

22

Are there any known laws explicitly allowing or preventing this behavior?

It's not the laws, it's what's in the note - the mortgage contract. I read my mortgage contracts very carefully to ensure that there's no prepayment penalty and that extra funds are applied to the principal. However, it doesn't have to be like that, and in older mortgages - many times it's not like that.

Banks don't have to allow things that are not explicitly agreed upon in the contract. To the best of my knowledge there's no law requiring banks to allow what your friend wants.

14

littleadv's first comment - check the note - is really the answer.

But your issue is twofold -

Every mortgage I've had (over 10 in my lifetime) allows early principal payments. The extra principal can only be applied at the same time as the regular payment. Think of it this way - only at that moment is there no interest owed. If a week later you try to pay toward only principal, the system will not handle it. Pretty simple - extra principal with the payment due. In fact, any mortgage I've had that offered a monthly bill or coupon book will have that very line "extra principal." By coincidence, I just did this for a mortgage on my rental. I make these payments through my bank's billpay service. I noted the extra principal in the 'notes' section of the virtual check. But again, the note will explicitly state if there's an issue with prepayments of principal.

The larger issue is that your friend wishes to treat the mortgage like a bi-weekly. The bank expects the full amount as a payment and likely, has no obligation to accept anything less than the full amount. Given my first comment above here is the plan for your friend to do 99% of what she wishes:

  1. Put aside 1/2 the payment when each paycheck comes.
  2. Make the regular payment if that's what's in the saved pile of cash each month.
  3. Twice per year, she will see an extra half payment, i.e. 1-1/2 times the needed money set aside.
  4. When (3) occurs, make the payment with additional principal equal to the 1/2 payment. This will happen twice a year, effectively making 13 full payments a year.

Tell her, there's nothing magic about bi-weekly, it's a budget-clever way to send the money, but over a year, it's simply paying 108% of the normal payment. If she wants to burn the mortgage faster, tell her to add what she wishes every month, even $10, it all adds up.

Final note - There are two schools of thought to either extreme, (a) pay the mortgage off as fast as you can, no debt is the goal and (b) the mortgage is the lowest rate you'll ever have on borrowed money, pay it as slow as you can, and invest any extra money. I accept and respect both views. For your friend, and first group, I'm compelled to add - Be sure to deposit to your retirement account's matched funds to gain the entire match. $1 can pay toward your 6% mortgage or be doubled on deposit to $2 in your 401(k), if available. And pay off all high interest debt first. This should stand to reason, but I've seen people keep their 18% card debt while prepaying their mortgage.

  • I don't accept view (b) here, for two reasons. 1) It's also the biggest amount of borrowed money you're likely to ever owe, and 2), it's still a significantly higher rate than you can safely make in the markets. Any prepayment applied to principal is exactly equivalent to a 100% risk free investment that yields the interest rate for the remaining life of the loan, and you won't find that investment anywhere in stocks or bonds; getting anywhere near a mortgage-rate yield involves assuming significant risk. – Mason Wheeler 7 hours ago
  • And that's why I respect those who follow (a). I don't respect the view that somehow one should prepay a 4-5% mortgage ahead of either 18%+ credit card debt or the chance to get a 100% 401(k) match. As far as risk goes, it's the subject of an article I'm writing. The last 100 15 year rolling periods all showed a positive return and all but 4 returned over 4%. I'm pretty happy with having over $400K more in my 401(k) for the fact that I still owe $150K on my mortgage. And the last 20 years had 2 bad crashes. – JoeTaxpayer 6 hours ago
4

Some lenders want to discourage the borrower from making these additional payments because they want to sell this as a service. They might set this up for you, or they have a contract with a 3rd party to set it up.

These services generally charge you to initiate the process, and may have a recurring fee. They take 1/2 a payment every 2 weeks. Then forward the money on the first of the month to the lender. Once a year they will send in the 13th monthly payment. This gives them control of up to a months payment per account.

There is no law that says they have to accept early payments. So check the documents to make sure it is allowed for that mortgage. Then send in a test payment directing that the excess funds go to pay down principal. Verify online that the extra funds were credited correctly. Even it works once the borrower will have to keep checking to make sure it is handled correctly each month.

0

Many mortgages penalize early payment, and I assume it's possible to disallow it altogether.

It makes sense why they don't want early payment. If you pay off the loan early, it is usually because you re-financed it to a loan with a lower rate. You would do this when the interest rate is low (lower than when you got your original loan).

If you pay it off early, that means they will have to re-invest the money again, or they will lose money if they just have it sitting around. However, recall above that people pay it off early when the interest rate is low; that is the worst time for them to re-invest this into another mortgage, because the rate will not be as good for them as the one you were originally going to keep paying.

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Consider this:

You borrowed from the bank $100000 at fixed 5% interest rate. Let's assume for simplicity it's a bullet loan where you pay ALL interest and the full borrowed amount after 10 years, i.e. you pay $100000*1.0510 = $162889.46 after 10 years.

Market rates become lower, reaching 0%.

Now if you pay the bank $100000, where is the bank going to invest the money to obtain 5% interest on it, if market rates are $0? According to the contract, the bank expects $162889.46 after 10 years, and $100000 can't be invested to become $162889.46 within 10 years anymore.

For the bank to accept the money to pay off the loan, you would have to pay $162889.46.

So, if the loan is a fixed-rate loan and not a variable-rate loan, and the market rates become lower, the bank will NOT accept the borrowed amount as a payment to fully pay off the loan. You have to pay more.

The analysis is slightly more complicated for loans other than bullet loans, but the basic conclusion remains the same: once interest rates become lower, the amount to pay off the loan becomes higher.

  • Oh, how I like the unexplained downvotes. – juhist Aug 6 at 15:22
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    -1 Rates on mortgages are historically low and banks are still making money hand over fist. – RonJohn yesterday
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    The fact that interest rates can drop is part of the risk of being a bank and is not the customers' responsibility. Interest is the bank's tool to account for risk. If they can't afford to do business at a particular rate, then they need to cut costs or increase their rates. And increased rates but be balanced with the decreased number of loans they will sell if their rates are higher than the competition. – Jaquez yesterday
  • By the way, I didn't down vote but I suspect the unclaimed one may have been because you explained why (according to you) banks may not want prepayment, which was not the question asked. – Jaquez yesterday
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    Because it's cross-linked from another question and doesn't apply to the other question. Boo. In any case, this analysis is meaningless for normal fixed-rate loans. – Joshua yesterday

protected by Chris W. Rea Jul 20 at 14:03

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