MortG is a multi-function mobile application designed for mortgages. Available for the USA and Canada market, in French, English and Spanish, this app does it all from calculating payments, closing costs, pre-approval, rent/own analysis, paying down, refinancing, debt consolidation, penalties, buying point analysis, ARM vs VRM, Retirement Plan and Reverse Mortgage Analysis…
When consumers are shopping for a mortgage, they are often presented with the idea of paying their mortgage early prior the end of its amortization. This option is often packaged with an Accelerated form of payment either weekly (making 4 additional payments a year) or bi-weekly (making 2 additional payments a year).
Paying Down your mortgage: theoretically
Situation: Client is taking a mortgage of $96,720 with an amortization of 25 years and a fixed interest rate of 5%. As show on the screen, MortyG provides the different forms of payments available. We see that if the client selects the Accelerated Weekly option, the payment will be $140.63. The accelerated form of payment will save the client $11,953 in interest and shortened the amortization from 25 years to 21.44 years
Screen 1 on MortyG, showing the different payments available of a specified mortgage amount, mortgage rate and amortization.
Is this true?
In theory it is. However it is based on these assumptions:
a) That the term length is equaled to the amortization and;
b) That the mortgage rate remains the same throughout the entire amortization leading to no change in mortgage payments.
As we can see any of these two conditions are unlikely to happen and this means what happens in practice will be different than what is illustrated theoretically. So lets look at what really will happen by using the paying down calculator of MortyG.
Paying down your mortgage: in practice
Situation: same as above but the client decides to select a monthly payment. He will still pay down the mortgage by the same amount every year than if he had taken the Accelerated Option by paying down the mortgage every year by $563 (as shown in screen 2).
Screen 2 shows the PayDown Screen where you can select the form of prepayment by increasing each payment, lump sum every year or one lump sum at a specific time.
Now In screen 3, we can also add additional payments by entering them individually. The user can also change the interest rates at renewal (every year in this case) by selecting an interest trend short term or long term (we will see what this means next).
By pressing the results button we are brought to the next screen 4 that allows the user to review the pay down option he has selected.
In screen 3a and screen 3b of MortyG, the user can review the prepaid information. The user can also enter individual prepayment by scrolling down to a particular cell.
The user can also change the interest rates at renewals by selecting the appropriate interest rate trend.
Assuming that the user is happy with the information entered, he would press the update button leading to Screen 4. In screen 4, we see that the user by paying down his mortgage has only saved $4,896 which is quite lower than the theoretical amount of $11,953. We also see that it took 25 years to pay the mortgage and not 21.44 years. What happened?
In practice, Amortization matters!!!
A mortgage is a contract between you and the lender. A contract is made up of legal provisions which define what you can and cannot do. The mortgage contract has a provision for the selection of a mortgage term and a provision for what will happen at the end of this term. A mortgage contract also has a prepayment provision which is usually linked to a penalty provision.
A mortgage contract does not have a provision dealing with reducing the amortization. Therefore any changes to the amortization is done outside of the mortgage contract. In reality you are refinancing the mortgage; however since there is no risk, this will not constitute a new mortgage and a new mortgage contract.
Basically it is the same as a life insurance policy. If you want to reduce your death benefit, this can be done outside the contract through an endorsement and will be allowed by the insurer as there are no increases in risk. Same thing with a mortgage. The lender will allow you to reduce the amortization however if you need to go back to your earlier amortization, this would be considered as taking a new mortgage subject to qualifying for it.
Changes to amortization are not automatic…
When your mortgage comes up for renewal, even if you have prepaid the mortgage by a certain amount, the lender cannot automatically reduce the amortization. As a result, you would have to ask this at renewal. If you don’t ask it at renewal, the lender will keep the amortization the same. What your prepayment will change as a result is your mortgage payment by lowering it.
This is what happened here. With a term of one year, the yearly prepayment of $563 reduces the mortgage balance every year, which leads to a lower and lower mortgage payment. In fact by the end of the mortgage we see that the mortgage payment was reduced to $354 from the initial amount of $563
By paying less and less payment every year, you save less and less interest on your mortgage and this is why the interest saving is reduced from the $11,953 to $4,896.
PLEASE NOTE: While your interest saving has been reduced to $4,896, you have to also account for the fact that you have paid less in mortgage payments. We did not include this difference of payment savings as it outside of the mortgage.
We also see in Screen 4 that the mortgage is paid in year 25 and not 21.44. Mathematically, when you prepay a mortgage, whether your amortization will be reduced will be based on the last renewal and term selected. In our case the term is 1 year and the prepayment was done at the beginning of year. As a result, the mortgage payment was calculated for the beginning of year 25 to end of year 25. This is why the mortgage ends at year 25. If the user had selected a term of 5 years, then the amortization would have been reduced base on the prepayments made for the last 5 years. As shown in Screen 5, a 5 year term shortens the amortization by 5 payments increasing the interest saving to $5,874. Please note that the last mortgage payment is $426 higher than the last mortgage payment for the term of 1 year which was $354
Changes to amortization are almost impossible to administer:
I am certain that you think that the easy solution is to change the amortization every year to pay the mortgage in the allotted time of 21.44 years. Well it is not that simple and some fancy calculations would be required.
If you change the amortization, any prepayments will now be based on the new amortization and this means you will now be prepaying too much. If nothing is done and every year the amortization is changed, you will compound the prepayments leading to the mortgage being paid in 15 years instead of 21.44 for example. Either the prepayment would have to be adjusted every year or the mortgage payment would have to be adjusted to be calculated on the amortization of 25 years instead of the adjusted amortization. At this point this becomes a complicated exercise.
Beware of shortening your amortization
Situation: The client has been prepaying his mortgage every year and he has now reduced his amortization legally to 20 years from the original 25 years. Interest rates are rising quickly and now the client is thinking about taking a longer term of 5 years versus 1 year. This term change also increases the mortgage rate. The client has some financial difficulties with his spouse having lost work and he can’t afford the new 5 year payment based on a 5 year rate and 20 year amortization. He would like to go back to his amortization of 25 years. Can he do it?
The answer is negative. This would be a full refinancing which involves a big risk. If his financial situation is very bad, the lender could decline to change the amortization to 25 years and even could refuse to renew the current mortgage at 20 year. The lender could also decide to charge an even higher mortgage rate associated with someone having poor credit or poor income…
My advice is too never shorten the amortization. The best solution is to prepay your mortgage, save some interest and pay less in mortgage payment and use the difference between the reduced mortgage payments and original payment to start investing (invest the difference). If you want to prepay your mortgage the earliest possible, then select the longest term. However as this would come with a higher interest rate, you could end paying a lot more interest if interest rates stay the same or decrease. However if interest rates increase, this would save you a lot of money.This is why interest trends are so important in these kind of decisions.
MORTYG is the only mortgage calculator that accounts for mortgage trends!!!