"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.
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. That payment includes the interest due for April. 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 for April 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 in exactly 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 June 1 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, Amortization Schedule Including Tax Savings. To see how amortization is impacted by extra payments, use 2a, Mortgage Prepayment Calculator: Extra Monthly 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.
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.