Prepayment Penalties and Biweekly Payment Schemes

From an email:

I was wondering if you could tell me whether the following ways to save on interest are actually possible. If they are what are the penalties typically associated with these suggestions. I know you have mentioned a pre-payment penalty but what amount is reasonable?

1) Pay a certain amount over your monthly mortgage payment to pay your mortgage off sooner, pay more in principle, and to save on interest. Example: Your minimum monthly payment is $2000 so you pay $2200 a month instead.

2) Pay your mortgage twice a month so that more principle is paid off before interest catches up. Another nice thing about this is that most people are paid twice a month.

Prepayment penalties are something that is associated with the loan your loan officer chooses for you when you sign up. They become set in stone when the documents are signed, the loan is funded and the documents are recorded.

Sad to say, only a very small minority of clients ask about pre-payment penalties at sign up, and judging from my experience with people at a later time, most people either cannot spot it in the documents (there should be a section entitled something like "Pre-Payment" or "Borrower's Right to Pre-Pay". On the other hand, you need to read the whole Note that you're signing enough to understand what every piece says).

As I've said in Mortgage Markets and Providers and Yield Spread Explained, pre-payment penalties are a function of the market you're shopping in. Not necessarily the best market you can shop in, but most loan officers are going to be looking to make money, not necessarily to get you the loan that's really the best possible loan. Pre-payment penalties add to what they get paid, and it's invisible to the client while you're getting the loan unless you go looking for it. In all markets, there is a trade-off between what you pay in up-front costs to get a given rate on a given type of loan, and what rate you get. Adding a pre-payment penalty (or not removing one) adds to the loan provider's commission, sometimes multiple points, and out of this they give you back a half point or so to make their loan look more competitive. A Good Question to ask and catch many loan officers off-guard is "and what is it without any pre-payment penalty?"

Pre-payment penalties are a thing to avoid if you reasonably can. On the other hand, circumstances can force you to accept one. No loan officer works for free, and if about all you've got is the money for the down payment, accepting a two year pre-payment penalty (meaning it is in effect for two years) can get the loan officer paid while you still get a affordable rate at a cost that is within your means.

Here in California, the maximum pre-payment penalty is six months interest, and that is the industry standard for when there is a pre-payment penalty. A few lenders will pro-rate it, but for the vast majority, they will charge the same penalty on the day before it expires as on day one. This is pure profit, and they're generally not going to turn down pure profit any more than most people will turn down a bonus. So if your interest rate is 6 percent, you're going to pay a 3 percent pre-payment penalty if you sell or refinance before the pre-payment penalty expires. For Negative Amortization loans, the pre-payment penalty is based on the real rate, not one percent, of course.

On some loans, the pre-payment penalty is triggered by paying any extra money. One extra dollar and GOTCHA! But probably eighty percent or so give you the option of paying it down a certain amount extra each year, usually 20 percent of the principal at year's beginning, without triggering the pre-payment penalty. This amount INCLUDES the normal pay down of principal via the monthly payments, so if you have a $200,000 balance at the start of the year, a lump payment of $40,000 is going to trigger the penalty because the regular payments will then push the pay down over 20%.

Now as to the alternate payment schemes you mention, the first method, paying extra, is very possible and recommended with most mortgages. Anything extra you pay should be applied directly to principal. Especially in the early years of the mortgage, this has a multiplier effect, as now that you don't owe that money any more, your interest charges in the future will be less so less of your payment goes to interest and more to principal. On a $300,000 30 year mortgage at 6%, your monthly payment is $1798.65. Of this, $1500 is interest - which you're paying just to break even - and 298.56 is principal, which actually goes to pay off your loan. Let's say you pay $200 per month extra. If you're one of those extremely rare people who actually pay off your mortgage, you'll be done in 278 months - 82 months early. Almost 7 years. The interest you pay drops from $347,514 to $256,000 - you saved $91,514 in interest charges by paying $200 per month early.

If, as is far more likely, you refinance after 2 years, instead of owing $292,404, you'll only owe $287,284, a savings of $5120, which means you owe $5120 less on your refinance, and might get better terms because of it. Or you have $5120 more in your pocket if you sell. So it's only a 7.5% rate of return - it is guaranteed. If this mortgage outlasts 95% of all loans and makes it to five years - sixty months - you'll only own $265,114 instead of $279,163, a difference of $14,049. This is money in your pocket or money you don't owe on the refinance, which you're not paying fees on, and which might get you a better deal. Or it's $14,049 more from the sale of your property to buy another one. It's a 17 percent overall return on every penny in you added in five years, including the last payment you made. That's better than you'll do with CDs with the first month's money.

Suppose you only make one extra payment, once. Let's say you make an extra payment at the end of the month when you buy or refinance instead keeping the money in your checking account until the end of the next month. Making that one payment saves you more than five months at the end of your mortgage if you keep it the full thirty years. Let's say you just pay $200 extra once, that first month that you actually make a payment. You owe $225 less after 24 months, $270 less after 5 years, and $1207 less in the last month of your loan (assuming you keep the loan the full thirty years).

Furthermore, the higher your interest rate, the more difference these payments make.

Your second question, about paying your mortgage twice a month, is trickier, and here's why: What most people who do this are doing is actually making payments every two weeks, not every half month, which means you're making an extra payment per year in pure principal. To separate the two phenomena, let's drag the calculator out. Cut the interest rate in half, cut the payment in half, and double the number of payments. Punch in n=720, i=3%, and let's see what happens. The payment comes out to $898.92. Double this to $1797.85. This is about 81 cents per month difference. If you pay half of the $1798.65 twice per month, you shave less than half a month off of your payment schedule.

On the other hand, make 13 payments in 12 months, and (to make things simple for a simple calculator) that's roughly equal to making payments of $1948.54 per month, which has you done in the 295th month - almost five and a half years early.

So you see, the twice a month schedule really does comparatively little for you - it's the fact that you are making an extra payment per year that really helps in this case.

So with some banks charging hundreds of dollars to sign you up for things like this (I know of lenders who charge $400 and up just to sign up), I'd suggest instead to instead spend the sign-up money on a direct pay-down of your mortgage (providing you don't have one of those "one extra dollar" prepayment penalties), and keep making those monthly payment with a little extra on the side instead.

This "service" banks provide for their customers is nothing more than a cash-cow fee to pad their own bottom line, all for something the vast majority of borrowers have the right to do for themselves for basically nothing.

And for the rest of you out there, I say the same thing I said to this person "Please ask if you have further questions you'd like answered."

Caveat Emptor

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