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How does paying off a mortgage early work? Example:
I have a 30 year fixed rate mortgage of 3.5%, the amount borrowed is $300,000. I have just inherited $300,000. I am in the first year of the mortgage. Can I give the bank the $300,000 to clear the mortgage, or must I pay off the total interest that was agreed upon for the 30 year term?
I'm curious why the bank would let you do this, since they will lose out on a lot of profit.
Can I give the bank the $300,000 to clear the mortgage, or must I pay off the total interest that was agreed upon for the 30 year term?
This depends on the loan agreement. I had one loan where I was on the hook regardless. Early payment was just that, early payment. It would have allowed me to skip months without making payments (because I had already made them).
Most loans charge interest on the remaining balance. If you pay early, it reduces your balance, decreasing the interest. If you pay it off early, there's no more balance and no more interest.
I'm curious why the bank would let you do this, since they will lose out on a lot of profit.
But they have their money back and can loan it out again. If they maintained the loan, they aren't guaranteed of getting their money.
Interest is rent that you pay for the loan of the money. Once you return the money, why pay more rent? While some apartment leases require paying through the entire term, most allow for early termination with proper notice. You give back the apartment; the landlord rents it out again. Why should they get paid two rents?
Another issue is that if someone with a mortgage switches jobs to a new location, that person will likely prefer to sell the current house and buy one in the new location. This is actually the typical way for a mortgage to end. If the bank did not allow that, they would essentially force the family to rent out the mortgaged house and rent a new house. So the bank would go from an owner-occupied house that the inhabitants want to keep maintained to a rental, where the inhabitants only care to the extent of their legal liability.
Consider the possibility that the homeowners lose one of their jobs. They can't afford the house. So they sell it and close out the mortgage. Should the bank refuse to allow the sale and attempt to recover the interest from the impoverished homeowners? That situation would almost guarantee an expensive foreclosure.
Once there is any early termination clause for any reason, it makes sense for the bank to structure the loan to include the possibility. That way they don't have to investigate whatever excuse is involved. Loan regulators may require this as well, particularly on mortgages.
Usually not the total interest, but all interest accrued and unpaid to date. This is called the "Loan Payoff Amount", and repays the bank their principal plus the "true" cost of capital on that principal since your last amortized payment (which is probably never, since you just signed the loan papers).
There may also be a "prepayment penalty". This is something that should have been disclosed to you if it exists, but it's fairly rare in U.S. mortgages anymore.
The theory is, the bank got the money they paid you at the start of the loan by selling a bond package backed by your mortgage and others of similar credit history and/or about the same time (a "mortgage-backed security"). By turning around and paying early, you meet your obligation, but the bank is now stuck with at least 10 years of quarterly coupon payments on that bond, which they were expecting to pay using your mortgage interest. For their trouble, you would pay an additional amount that either covers their "call price" on the portion of the bonds used for your principal, or simply buys them the time to re-issue a new mortgage using your repaid principal to back the bond again.
In the modern housing market, such a prepayment penalty is very rare, because so many lenders are willing to give you a mortgage without one, and so many buyers balk at the thought of having to pay more if they pay early; the whole point is to pay less by paying early. Just something to look up in your mortgage documentation.
They also eliminate the risk associated with that loan, and get the money back to find a loan to someone else, possibly at a higher rate. It really is just about financially neutral for them.
How does paying off a mortgage early work? Example:
I have a 30 year fixed rate mortgage of 3.5%, the amount borrowed is $300,000. I have just inherited $300,000. I am in the first year of the mortgage. Can I give the bank the $300,000 to clear the mortgage, or must I pay off the total interest that was agreed upon for the 30 year term?
This depends on the country regulation and your agreement. Generally speaking the calculations are on daily reducing balance. so you just pay 300K
I'm curious why the bank would let you do this, since they will lose out on a lot of profit
We payed off our Mortgage early...at first in small extra payments to principal, and finally a lump sum. Each extra payment to principal reduced the balance, and reduced every payment going forward. I have, somewhere, an excel spreadsheet where I tracked this... - =CUMIPMT((interestRate/12),term,pymtNumber,balance,balance,0) computed the interest payment due - =currentPrincipal + CUMIPRINTresultAbove computed the monthly principal payment
Occasionally I would update the month-ending Principal balance against what the mortgage company told me. It was usually off by a little.
My mortgage company required me to specifically contact them for a payoff amount before I wrote the final check.
I've never heard of a mortgage where prepayment of all expected interest following the original schedule is required. I would guess it is against federal (US) law. Lets think about that for a moment... out of "interest", I recently computed that for our 30 year loan at 6-5/8% on about 145, we payed a total of 106000 in interest. That include a refi to 4-7/8 10-years in to a 15-year loan, and paying it off 20 years after the original loan was granted.
As far as not paying all the theoretical interest due... - If they get a fixed dollar amount of service interest back, there's no incentive to me to pay on-time. I owe the same amount if I pay it today or if I pay it 6 months late, after I gambled the mortgage money and finally won. (yea, I know they could write the mortgage to penalize me for paying late, but I'm ignoring that) - if you were requried to pay off all the interest that might accrue, how could you ever sell your home, or refinance, for that matter? When I refi'd, the new holder payed the old holder 98,000. If the original holder had required prepayment of all the interest that would be accrued to the original schedule, the new mortgage would've been 200k. It would just never be a good deal to buy a home if mortgages worked under that term.
I have had a car loan that worked differently -- they pre-computed the total interest due and then divided it over the term of the loan equally. I could pay off early and they stopped collecting interest.
The short answer is: banks are less concerned about the interest earned on any single mortgage than they are for the interest earned over time from a collection of mortgages.
Let's look at a repayment schedule for a 30-year mortgage at 4% for $100,000.
Principal Interest Balance
Year 1 $1,761.09 $3,967.95 $98,238.91
Year 2 $1,832.85 $3,896.19 $96,406.06
Year 3 $1,907.52 $3,821.52 $94,498.54
Year 4 $1,985.22 $3,743.82 $92,513.32
Year 5 $2,066.11 $3,662.93 $90,447.21
Year 6 $2,150.30 $3,578.74 $88,296.91
Year 7 $2,237.89 $3,491.15 $86,059.02
Year 8 $2,329.07 $3,399.97 $83,729.95
Year 9 $2,423.95 $3,305.09 $81,306.00
Year 10 $2,522.72 $3,206.32 $78,783.28
Year 11 $2,625.49 $3,103.55 $76,157.79
Year 12 $2,732.47 $2,996.57 $73,425.32
Year 13 $2,843.77 $2,885.27 $70,581.55
Year 14 $2,959.66 $2,769.38 $67,621.89
Year 15 $3,080.22 $2,648.82 $64,541.67
Year 16 $3,205.73 $2,523.31 $61,335.94
Year 17 $3,336.33 $2,392.71 $57,999.61
Year 18 $3,472.25 $2,256.79 $54,527.36
Year 19 $3,613.72 $2,115.32 $50,913.64
Year 20 $3,760.94 $1,968.10 $47,152.70
Year 21 $3,914.16 $1,814.88 $43,238.54
Year 22 $4,073.64 $1,655.40 $39,164.90
Year 23 $4,239.63 $1,489.41 $34,925.27
Year 24 $4,412.33 $1,316.71 $30,512.94
Year 25 $4,592.09 $1,136.95 $25,920.85
Year 26 $4,779.21 $949.83 $21,141.64
Year 27 $4,973.91 $755.13 $16,167.73
Year 28 $5,176.55 $552.49 $10,991.18
Year 29 $5,387.45 $341.59 $5,603.73
Year 30 $5,603.73 $122.11 $0.00
(source: http://web5.vlending.com/loancenter-calculators-amort.aspx. Any mortgage calculator should produce a similar schedule, however.)
A few things to note:
The interest due in the last 6 years is less than the interest due in the first year alone. Banks are getting a disproportionate amount of the expected interest up front.
Banks can make multiple loans; the money collected from existing borrowers can be aggregated to make new loans before the old ones are paid off, and those new loans start, of course, at the interest-heavy end of the repayment schedule. Suppose the bank lends out $1,000,000 to 10 borrowers. In the first two years, they will collect a total of $114588.90 from the 10 borrowers in principal and interest. That's enough to make an additional loan to an 11th borrower while keeping $14,588.90 as "profit". The new borrower is making payments at the year-one rate.
A bank may lose a little interest on a single loan that gets repaid early, but that is generally made up by the fact that a new loan can be issued that much sooner as a result.
Here's one way to think about it: You're basically renting the loan principal from the bank. Interest is the "rent money" you pay for the privilege of using their principal money. If you don't need to use their money for very long, then you don't have to pay a lot of rent on it, and then they can go and rent that pile of money to someone else.
