Mortgage Prepayment When You Have Two Mortgages
July 6, 2004, Revised January 29, 2007, November 26, 2008, Reviewed July
21, 2009
When you have two mortgages and funds are available for repayment, the question arises as to which of the two should be repaid. In the first situation described below, there is an unambiguous answer, but in the second there isn't.
"Please settle a dispute. On one property I have an old 6.6% mortgage with small balance and only 5 years to go, and on another property I have a relatively recent 30-year mortgage at 6.25 %. Most of the payment on the first mortgage is principal while most of the payment on the second is interest. I say that any excess funds we apply should go to the 6.25% mortgage because so little of the payment is being applied to principal, but my wife thinks we should apply excess funds to the higher-rate mortgage."
Score one for your wife. You should allocate excess funds to the higher rate loan.
The composition of the scheduled payment changes over time, as you note. Early in the life of a mortgage, most of the payment goes to interest, but as the balance falls over time, an increasing share goes to principal.
For example, your old loan with a $20,000 balance at 6.6% and 7 years to run has a payment of $ 298, of which $188 goes to principal and $110 to interest. Your new loan of $50,000 at 6.25% with 29 years to run has a payment of $312, of which $52 goes to principal and $260 to interest.
However, if you add to your scheduled payment, 100% of the increment goes to principal in both cases. If you add $100, the principal payments on the two loans would rise to $288 and to $152, respectively. You would earn 6.6% on this $100 if you applied it to the first loan, and 6.25% if you applied it to the second.
In short, how your scheduled payment is being divided as between principal and interest should have no bearing on how you allocate excess funds.
"My wife and I recently purchased a new home and avoided mortgage insurance by taking a piggyback: Our first mortgage is a 5 year interest-only ARM for $296k @ 5.375% for 30 years. Our second mortgage is a 15 year FRM for $55k @ 7.01%. Our cash flow allows us to pay more than the interest on the ARM and the full payment on the FRM. Should we apply the excess to the ARM or to the FRM?"
The general rule is to pay down the higher-rate debt first, which is the second mortgage. If both mortgages were fixed-rate (FRMs), this would be a no-brainer, you would allocate all surplus cash to the second until it was paid off. The same is true when the first mortgage is a 5-year ARM and you confidently expect to be out of the house within 5 years.
On many piggybacks, the first mortgage is fixed and the second adjustable with a higher rate. In this case also you would channel excess cash flows toward the second.
But if the first mortgage with the lower rate is adjustable and your time horizon extends beyond the first rate adjustment, or if you are uncertain about it, the decision is trickier. While you should start by paying down the higher rate second, if market rates spike during the first 5 years, the rate on the ARM could jump by as much as 5% at the first rate adjustment, which would bring it to 10.375%. In that case, at some point before the rate adjustment, you should start paying down the ARM.
I can’t tell you exactly when to do this, you will have to rely on your gut.
But your gut needs to be kept informed regarding the ARM rate expected at the first rate adjustment. This is easy to do but you must know the index used by your ARM, the margin, and the caps, all of which are shown in your note.
The expected rate at the first rate adjustment is the most recent value of the index, plus the margin (which doesn’t change), subject to caps. Usually the rate on a 5-year ARM cannot increase by more than 5% at the first adjustment. As the index changes over time, the expected rate changes correspondingly.
If the expected rate climbs above the rate on the second mortgage, you have to think about whether and when to switch gears. The case for the switch gets stronger the higher the expected rate and the closer you get to the ARM rate adjustment.
When you have two mortgages and funds are available for repayment, the question arises as to which of the two should be repaid. In the first situation described below, there is an unambiguous answer, but in the second there isn't.
Pay Down the Newest Loan, or the Loan With the Higher Rate?
"Please settle a dispute. On one property I have an old 6.6% mortgage with small balance and only 5 years to go, and on another property I have a relatively recent 30-year mortgage at 6.25 %. Most of the payment on the first mortgage is principal while most of the payment on the second is interest. I say that any excess funds we apply should go to the 6.25% mortgage because so little of the payment is being applied to principal, but my wife thinks we should apply excess funds to the higher-rate mortgage."
Score one for your wife. You should allocate excess funds to the higher rate loan.
The composition of the scheduled payment changes over time, as you note. Early in the life of a mortgage, most of the payment goes to interest, but as the balance falls over time, an increasing share goes to principal.
For example, your old loan with a $20,000 balance at 6.6% and 7 years to run has a payment of $ 298, of which $188 goes to principal and $110 to interest. Your new loan of $50,000 at 6.25% with 29 years to run has a payment of $312, of which $52 goes to principal and $260 to interest.
However, if you add to your scheduled payment, 100% of the increment goes to principal in both cases. If you add $100, the principal payments on the two loans would rise to $288 and to $152, respectively. You would earn 6.6% on this $100 if you applied it to the first loan, and 6.25% if you applied it to the second.
In short, how your scheduled payment is being divided as between principal and interest should have no bearing on how you allocate excess funds.
Pay Down the First Mortgage or the Second?
"My wife and I recently purchased a new home and avoided mortgage insurance by taking a piggyback: Our first mortgage is a 5 year interest-only ARM for $296k @ 5.375% for 30 years. Our second mortgage is a 15 year FRM for $55k @ 7.01%. Our cash flow allows us to pay more than the interest on the ARM and the full payment on the FRM. Should we apply the excess to the ARM or to the FRM?"
The general rule is to pay down the higher-rate debt first, which is the second mortgage. If both mortgages were fixed-rate (FRMs), this would be a no-brainer, you would allocate all surplus cash to the second until it was paid off. The same is true when the first mortgage is a 5-year ARM and you confidently expect to be out of the house within 5 years.
On many piggybacks, the first mortgage is fixed and the second adjustable with a higher rate. In this case also you would channel excess cash flows toward the second.
But if the first mortgage with the lower rate is adjustable and your time horizon extends beyond the first rate adjustment, or if you are uncertain about it, the decision is trickier. While you should start by paying down the higher rate second, if market rates spike during the first 5 years, the rate on the ARM could jump by as much as 5% at the first rate adjustment, which would bring it to 10.375%. In that case, at some point before the rate adjustment, you should start paying down the ARM.
I can’t tell you exactly when to do this, you will have to rely on your gut.
But your gut needs to be kept informed regarding the ARM rate expected at the first rate adjustment. This is easy to do but you must know the index used by your ARM, the margin, and the caps, all of which are shown in your note.
The expected rate at the first rate adjustment is the most recent value of the index, plus the margin (which doesn’t change), subject to caps. Usually the rate on a 5-year ARM cannot increase by more than 5% at the first adjustment. As the index changes over time, the expected rate changes correspondingly.
If the expected rate climbs above the rate on the second mortgage, you have to think about whether and when to switch gears. The case for the switch gets stronger the higher the expected rate and the closer you get to the ARM rate adjustment.