August 18, 2000, Revised August 4, 2004, December 1, 2006, July 9,
2007
"After reading several of your articles on paying off mortgages early, I
came to the conclusion that I really didn't understand the basic rules
of mortgage accounting. Can you explain them in a simple way?"
I'll try. While mortgage amortization accounting is not the easiest
thing in the world to understand, it isn't rocket science either. Since
borrowers are stuck with their mortgages for years, it is a good idea to
know how the accounting works.
Amortization Accounting
Except for
Simple Interest
Mortgages, the accounting for amortized home loans assumes that
there are only 12 days in a year, consisting of the first day of each
month. Your account begins on the first day of the month following the
day your loan closes. You pay "interim interest" for the period between
the closing day and the day your record begins. Your first monthly
payment is due on the first day of the month after that.
For example, if your 6% 30-year $100,000 loan closes on March 15, you
pay interest at closing for the period March 15-April 1, and your first
payment of $599.56 is due May 1.
The payment is allocated between interest and reduction in the loan
balance, which is called "principal". The interest payment is calculated
by multiplying 1/12 of the interest rate times the loan balance in the
previous month. 1/12 of .06 is .005. The interest due May 1, therefore,
is .005 times $100,000 or $500. The remaining $99.56 is principal, and
reduces the balance to $99,900.44.
The principal payment is always a residual, the difference between the
total payment and the interest due.
The process repeats each month, but the portion of the payment allocated
to interest gradually declines while the portion allocated to principal
gradually rises. On June 1, the interest due is .005 times $99,900.44,
or $499.51. The amount available for principal rises to $100.06.
While the payment is due on the first day of each month, lenders allow
borrowers a "grace period", which is usually 15 days. A payment received
on the 15th is treated exactly in the same way as a payment received on
the 1st. A payment received after the 15th, however, is assessed a late
charge equal to 4 or 5% of the payment.
Extra Principal Payments
When borrowers elect to increase the amount of their payment, the
principal payment increases by the same amount, so the balance is
reduced by that amount. For example, if the borrower paid $699.56 on May
1, the balance would drop by an additional $100 to $99,700.38, which in
turn would reduce the interest due in June to $498.51.
Extra payments that are made later in the month might have the same
effect, or might not be credited until the following month, depending on
the lender. To be credited within the same month, extra payments have to
be received before the Nth day of the month, but N varies from one
lender to another.
These rules are advantageous to many, perhaps most borrowers because of
the backdating of payments to the first day of the month. Thus, the
borrower who pays $599.56 on May 15 has the use of $599.56 free of
interest for 15 days. The same is true of extra payments received before
the Nth day of the month.
Mortgage Amortization Tools
Readers are encouraged to develop an actual amortization schedule which
will allow them to see exactly how the numbers change. They can do that
using one of my calculators. For straight amortization without extra
payments, use my calculator 8a,
Loan Amortization Including Tax Savings. To see how amortization is
impacted by extra payments, use 2a,
Term-Shortening and Interest-Savings From Making Extra Payments.
If you want to experiment with different payments and/or maintain a
permanent record of your loan, download one of my spreadsheets,
Extra Payments on Monthly Payment
Fixed-Rate Mortgages or
Extra Payments on ARMs.
Unlike the calculators which can't be moved from where they are, the
spreadsheets can be transferred to the hard drive of your computer.
Payment Rigidity
A major problem with the existing mortgage is the absolute rigidity of
the payment requirement. Skip a single payment and you accumulate late
charges until you make it up. If you skip May, for example, you make it
up with 2 payments in June plus one late charge, and you record a 30-day
delinquency report in your credit file. If you can’t make it up until
July, the price is 3 payments plus 2 late charges plus a 60-day
delinquency report in your credit file. Falling behind can be a slippery
slope into foreclosure.
Payment rigidity also prevents many borrowers from organizing their
personal finances in the best way. Some examples from my mailbox:
*Borrower A wanted to use a bequest to reduce the monthly payment on a
fixed-rate mortgage. No way. If A used the bequest to prepay principal,
it would shorten the period to term, not reduce the payment.
*Borrower B wanted to use a bequest to reduce the term on an adjustable
rate mortgage. No way. If B used the bequest to prepay principal, it
would reduce the payment, not shorten the term.
*Borrower C wanted to double his payment in December when he receives
his bonus and skip a payment in August when he has no income. No way. If
C used the extra payment in December to prepay principal, he still had
to make the payment for August.
*Borrower D is paid twice a month and wanted to make his mortgage
payment twice a month. No way. Borrower D must bank his mid-month
payment and pay the lender once a month.
No one instrument will meet everyone’s needs. Many borrowers who
actively manage their family finances, however, are ill-served by the
current amortized mortgage.