August 18, 2000, Revised September 23, 2008

"I have been adding $100 a month to my mortgage payment every month because I was told that this would result in paying off the mortgage in 21 rather than 30 years. Last week, however, I was told that because I had an ARM, there was no way to pay off early. Is this true?"

You can pay off an ARM early, but not without some careful planning. The difficulty is that every time the interest rate changes on an ARM, the mortgage payment is recalculated so that the loan will pay off in the period remaining of the original term. This means that, to pay off early, whenever the rate and payment change, your extra payment must increase to offset the reduction in your scheduled payment.

For example, if your mortgage was originally for 30 years and 5 years have elapsed, the payment for year 6 would be calculated over 25 years. Hence, any additional principal payments you made during the first 5 years would result in a lower monthly payment, but no change in term. If you continue with the same extra payment of $100, you would not get any shortening of term until after the last rate adjustment, which on would occur after 29 years. You might shorten the term from 360 to 357 months.

This points up an important distinction between fixed-rate and adjustable-rate mortgages that few borrowers consider. When borrowers make fixed extra payments to principal on a fixed rate mortgage, they shorten the term but don't change the payment. When they make fixed extra payments to principal on an ARM, they reduce the payment on rate adjustment dates, but don't change the term. This makes ARMs attractive to those who want to reduce their payments, and FRMs attractive to those who want to shorten their term.

To shorten the term significantly on an ARM, you must increase the extra payment at every rate adjustment date so as to offset the decline in the scheduled payment resulting from your prior prepayments. This is a pain, but I have a calculator that eases the pain substantially. This is Extra Payments Required to Pay Off By a Certain Period. Using this calculator to help you shorten the term of an ARM is described in Using a Calculator to Prepay ARM.

Postscript: To my surprise, some readers have interpreted this article to mean that prepayments on an ARM won't save them any money. That is not correct, every additional dollar they pay reduces the loan balance by the same amount, and thereby reduces their future interest bill.