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A family member once told me about a method for reducing the term of a mortgage "significantly".

They didn't know (or I can't remember) the details but it had to do with certain mortgages that recalculate the interest quarterly. From what I remember the idea is to make the monthly payments on time and then pay off a chunk of the principal at the end of each quarter, which results in lower monthly payments the following quarter. Done over and over, this seemingly can shave quite a few years off a mortgage.

I don't know much about mortgages and so my questions are:

  • is this as effective as I was told?
  • where can I find more information about it?
  • how would I ask a bank if they allow it? I can't imagine it being in their interest at all.

My first impression is that if I ever get a mortgage I'd want to do this to not end up paying zillions (of Euros) in interest over 40 years.

  • Home mortgages are different in every country. I think most people assume you're in the US, but if you're not, you should specify which country if you want useful advice. – lucius Aug 14 '10 at 7:15
  • I live in Spain but I don't know if I'll be getting a mortgage here. Also I doubt there is anyone on this site with knowledge of Spain's mortgage system, so general information about the topic is fine. – bob esponja Aug 14 '10 at 21:11
  • I don't know about quarterly recalculation (both of the mortgages I've had over the years were fixed rate), but I do know that paying extra principal regularly is a great thing to do if you want to kill that mortgage. When my wife and I bought our houses (first a "starter home" when we got married, and later a larger one when the kids came along) we made the decision that being debt-free was a priority, and vacations/new cars/big-ticket-items were not. First mortgage - paid in five years. Second - paid in seven years. Put every spare cent into paying them off. Best. Decision. Ever! – Bob Jarvis Jan 22 '14 at 18:16
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You mention Euros, so I'm not sure where your mortgage would be held. In the US, with mortgages I've had, you can prepay at any time without penalty. Any prepayment reduces your interest expense.

This calculator will tell you how much you can save (and how much you can reduce the term) by making prepayments. I don't know how well it will apply to non-US mortgages, which may calculate amortization differently.

This will not (in the US) however, reduce your monthly payments. Your payments will remain the same but the term of the loan will be reduced.

  • Thanks for the calculator, it will be handy to get an idea of how many years can be shaved off the mortgage. Re: the fact monthly payments aren't reduced, you're right; that is how it had been explained to me. I knew I had some details mixed up! – bob esponja Aug 12 '10 at 16:24
  • Just to be clear, at least in the US, your total payment won't change, but the ratio of principal to interest will change. That is where the term reduction comes from. – KeithB Aug 12 '10 at 17:10
  • @KeithB - by making a principal reduction (which one mortgage broker in the U. S. told me required at least $50,000), you can change the monthly payment. – justkt Aug 13 '10 at 18:14
  • @justkt - I've never heard of this before, and I don't think it is a standard part of mortgage contracts. There may be mortgages out there that do that, but they aren't common. – KeithB Aug 14 '10 at 13:26
  • @KeithB - in the United States, at least, I was told that all mortgages that allow early payment will allow a principal reduction. – justkt Aug 15 '10 at 3:03
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Another way of paying off the mortgage faster is making a payment every two weeks instead of twice a month or monthly. This essentiall results in one payment a year being entirely principal reduction. In addition, interest does not compound as quickly, because you are paying off the principal faster.

  • Just for clarification (though I'm sure you already know this, SchwartzE) - these are called bi-weekly programs. It's too bad that more lenders don't push for bi-weekly programs... then again, I suppose they would lose a lot of potential interest gains if all of their loans were bi-weekly. – Jagd Aug 12 '10 at 21:02
  • Isn't paying twice a month the same as every two weeks? Also does it imply making two full payments each month, or splitting the monthly payment into two half-payments? Could you explain the one payment a year being principal reduction a bit more, or link to somewhere that explains it? Thanks. – bob esponja Aug 13 '10 at 10:46
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    @bob: Twice a month = 24 payments per year. Every two weeks = 26 payments per year. (52 weeks / 2) – dthorpe Aug 13 '10 at 17:46
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    @bob esponja - every little bit helps. But BEWARE of "programs" that will put you on a biweekly schedule for a fee. There have been (and may still be) what I would consider to be scams around this kind of program. Any fee you pay will erase part of your savings. Be skeptical. – bstpierre Aug 16 '10 at 18:53
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    @bob "it seems like it would reduce the principal by a very small percentage" Yes, but anything you can do to lower the principal balance will help, right? Consider also that the split between interest and principal in each monthly note is not constant across all 360 payments in a 30 year loan. If your monthly note is 1000, in the first few payments the interest will be around 950, with only 50 going to principal. 29 years later, the interest per month will be around 50, with 950 going to principal. So if you prepay in the first few years, you can eliminate thousands in interest. – dthorpe Aug 16 '10 at 21:38
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Overpaying a mortgage is a pretty effective way of shortening the life of the loan - remember that the interest is calculated on the outstanding balance whenever the interest is recalculated (depending on your loan that can be anything from daily to once a year) so the smaller the outstanding balance, the less interest you have to pay.

The earlier you start this in the life of the loan, the shorter the repayment period will be as the portion of the payment that is allocated to the interest is largest at the beginning.

  • Thanks for mentioning interest recalculation - that was another important point that I'd forgotten. As it was told to me, the interest recalculation determines when it's best to overpay (iirc end of each month for monthly recalcs, just before the end of the year for yearly recalcs, etc). Am I remembering this correctly? – bob esponja Aug 13 '10 at 10:49
  • @bob esponja, that pretty much mirrors my understanding. However it also depends on you getting any interest on the money. If you barely get any, it's not that big a factor in the equation as you don't lose much by not 'timing' the payments. – Timo Geusch Aug 14 '10 at 4:51
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Be sure to ask your mortgage holder how they would like you to make prepayments. Some mortgage holders get confused if you send in a payment for less than the full monthly note - it may set off panic alarms at the bank.

Some lenders can get even more confused if you send two payments in one month - they may assume the unexpected payment is for the following month and apply the payment to next month's interest instead of paying down the principal. This actually happened to me several years ago - a phone call to the lender cleared things up.

Some lenders may charge a fee to "convert" a monthly note into a biweekly note. IMO, this isn't worth it in terms of my monthly cash flow. I'd rather be obligated to pay monthly but have the option to pay more often when I can than to be obligated to pay more often.

  • Good point, paying all that extra money for it not to reduce the principal would be p. embarrassing. – bob esponja Aug 14 '10 at 21:21
  • +1 Definitely ask! I confused my bank by making prepayments on a HELOC (only one got processed the wrong way fortunately). They were paid against interest and counted as a partial payment for the month, it was a minor mess to straighten out and the woman at the bank said I should just call her so she could properly make the transfers count as principal payments. – bstpierre Aug 16 '10 at 18:56
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How effective is it? It's as effective as your mortgage rate. If your mortgage is at 6%, it's a 6% per year return. The bank will let you pre-pay because, well, your mortgage is not all that special. When you pay back the money, they can just use it for something else. (This is the same reason they let you refinance your mortgage when rates get lower - a more wholesale version of the same thing.)

Now, the bank might possibly have to invest the money at lower rates, but that risk is already baked into the price of the loan when they give it to you, and it's a feature most people (at least in the US) expect from their mortgages. The bank can also buy derivatives on the open market so that if interest rates fall, they make back that money... or they can just risk it, if they're so inclined.

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In the States, where prepayment penalties are quite rare, you are welcome to make additional principal payments along with the mortgage any time. This is a snapshot for the first months amortization of a $200K/4%/30yr mortgage:

enter image description here

It's interesting to note that in month one, if you were to pay $289.12 in an extra payment, you would knock a month off the back end. The other way to look at it, is that you get to cross out both Month one and two when making that payment. Next month, you can't skip a payment, but you are in month 3 instead.

In the older days, a 12% rate would have the payment on this same loan over $2000 per month, but it would only take $58 or so to pay that next month's principal. Ironically, today's low rates means prepayments save you less as the math is the exact same as investing for up to 30 years with only 4% interest compounding for you. That's the punchline, the savings is the same rate as you pay on your loan, compounded over the time left on the loan.

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It bears noting that if you pay extra/early on your loan, then either your term will decrease or your payments will go down or a lesser combination of both. You can't have the best of both options. If you want the shortest term, you keep making the same payments after your lump payment. If you want the lowest payments, you keep the same term after your lump payment.

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