Why are monthly mortgage pre-payments applied to the back-end of the mortgage?
After having paid several years of 'extra' principal payment on my mortgage, I found that the extra monies were being applied the the 'back-end' of the mortgage instead of the 'front end'.
The reason this is important is that the mortgage interest on an amortized loan is higher on the front end than at the back end. If you look at an amortization table, the amount allocated monthly to PI (principal & interest) is not equal. The first several years of the mortgage is heavily weighted towards interest and very little towards principal.
A strategy some have said is to send exactly the amount of several months pre-paid principal payments along with the current months full P&I payment thereby not allowing the INTEREST for those future months of pre-paid PRINCIPAL to be collected. In other words. Payment #1 Principal & Interest PLUS payment of Principal for months 2, 3, 4 & 5 would circumvent Interest payments for months 2, 3, 4 & 5. That would save THOUSANDS immediately on the mortgage. Your next months payment would begin with Payment #6 P & I... and if you can afford to pay Principal for months 7, 8, 9 & 10... you would save even more THOUSANDS.
The problem with this strategy is that banks don't like it and do everything to discourage one from pre-paying up-front principal. They will gladly accept your payments and apply them to the 'back-end' of the loan.
I would like to know more about a method to force the banks to accept the payments on the 'front-end' to avoid paying interest. Is this possible? If so, how can I do this?
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Unfortunately, one of the characteristics of an amortized loan is that you pay interest up front and principal on the back end of the loan. If you are very aggressive about paying the loan down and pay off a significant percentage in a short period, you can ask the bank to re-amortize the loan to reduce the payments.
To do what you want to do, you need to find a "simple interest" mortgage. These exist, but are rare since the government doesn't buy them. A simple interest mortgage accrues interest daily similar to a credit card, so the lower your balance, the lower the interest payment.
These loans may or may not be a good deal for you, depending on a number of factors. Run the numbers carefully and understand what you are getting into. There's no such thing as a free lunch.
You are presuming something that isn't true, which is that applying to 'back end' saves you less money than the 'front end' does. When you apply an extra payment to the principal as a whole, it ends up reducing the principal on which you are paying interest. This reduces the interest owed over the life of the loan, which in a sense shifts the interest/principle allocation for every payment after the reduction in principle. A loan for a lower amount with the same duration would have lower payments, but since the payments don't drop, each one is now effectively paying off a tiny bit more principal than before, which means the loan is paid off quicker. If you reduce the principal by an amount equal to the next months principle payment, it effectively strips a month off the life of the loan.
No matter which way you do the math, viewing the coming month as removed and shift up the others, or viewing all following payments as now having a reduction in the portion that is interest, the end result is the same, the loan is paid off sooner
You can use the calculator at this site (or google for another) which allows the option of a one time payment. and view the effect and prove I'm right about the math on this.
For example, start with their default numbers, and have it calculate the payoff date. Make a note of what that date is.
Then click the green 'show year by year' link, and expand the first year (click the plus sign) to see the month by month details for that year. Now, take the principle amount for payment 2, stick it in the 'one time prepayment' field, and put a 2 in the 'before payment number' field. Have it re-calculate and you will notice that it stripped a month off the payoff date of the loan.
Of course we don't know the guts of that calculator so maybe it is applying the extra payment the front of the loan? maybe not. No matter, we can do the numbers a different way to simulate the 'back end' method and see what result we get.
To prove the reduced interest math, do this. Put in 155,000 for the loan amount. Notice that the second month's principal is 187.02 Round that to 187, subtract from 155,000 and enter that number (154813) as the loan balance and re-calculate (to get payments for a loan reduced by the first extra principal payment. Notice the monthly payment is 1$ lower. Now put into the monthly prepayment field, (so we are making the same payment as for the original 155k loan) and recalculate. The end date moves up one month. So yes, that tiny shift in effectively paying more towards principal on every payment along with the prepayment itself, pulls a month off the end of the loan.
Hence no matter if it goes to the 'end' or the 'front' you will save one entire payment, less the amount of prepaid principle, which is equal to the interest payment for month 2. Same net effect in total savings no matter how you do the calculation
First, you need to check the terms of your loan agreement to make sure there is no pre-payment penalty or contractual basis for them to apply extra payments in any other way than reducing the principal immediately.
Once you have confirmed that, you need to make sure to include with any extra payments instructions for how the overage is to be applied. Ideally you would write this in the memo section of the check in addition to a note with the payment.
I'm not sure about your back-end/front end theory, but I have seen where the lender can sometimes interpret extra payments as pre-payments of future monthly payments instead of applying them immediately.
Summary: If you are clear about your intentions and they don't have something written into the loan agreement to the contrary, this should be fairly trivial. In fact, I did it all the time with no issues at all on my mortgage with Wells Fargo.
Some time ago, I wrote a spreadsheet to help understand the impact of mortgage acceleration. (Note - I don't sell it, or anything else for that matter. I wrote it in response to mortgage acceleration scams, as a way of showing how simple the actual process really is.)
The sheet allows you to change the principal amount, interest rate, and prepayments. You'll note that for the numbers loaded, (0K, 6%, 30yrs) a prepayment of 0 at the outset knocks off a full payment at the end. Of course today's principal drops by just that 0, but its effect is multiplied over the 30 years. You can see how the amount of interest and principal changes each month, and how if in any given month you pay exactly "next month's principal" you cut a month off the back end.
Since interest is calculated based on the principal amount in any given month, it's not linear. I believe the term 'front-loaded' confuses the issue and adds nothing meaningful to these dialogs. You owe 0K. The interest rate is 5%. Why would anyone be surprised the interest in that first 12 months is close to K? And toward the end, when your balance is say, K, that year's interest is closer to just 00?
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