How to pay your mortgage

Roger Schlesinger
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Posted: Mar 13, 2007 7:28 PM

Something as easy as how to pay your mortgage should be a one paragraph column, but it isn't. As the industry has become more complex, the ways to pay your mortgage have also become more complicated. We have teaser rates, interest only rates, longer and longer terms on our loans, graduated payment loans and option arms with choices to be made each month. Add to the list is bi-weekly loans and the paragraph is over and all I have done is confused most of the readers. So now, I am going to spend the rest of the article giving you some ideas of how to pay your mortgage to best serve yourself.

First and foremost , you can pay any mortgage anyway you wish as long as you pay what is called for on the mortgage coupon. You can pay an interest only line as a fully amortized 15 year fixed. You can pay an option arm as an interest only loan or as a 15 year loan using the pay rate (teaser) as long as it covers the minimum (teaser) rate.. You can pay a 5 year arm as a fully amortized 5 year loan, even if it has a prepayment penalty attached. One can pay a 20 year fixed as a 10 year fully amortized loan. And having decided to one of any of the above you can change to another one each and every month. The caveat is always just to be sure you pay at least what the coupon is telling you to pay.

I am sure that at this point some of the readers are saying to themselves , and anyone who will listen ,that the 30 year fixed is the best loan for everyone because you can do as above and always have the "safety" of falling back to a 30 year. The reason that you shouldn't do that is the rate is too high. I will demonstrate the old adage; nothing beats a lower interest rate, and show you the fallacy of the above thinking.

A growing number of people are gravitating to the bi-weekly mortgage because it will pay your 30 year loan off in approximately 23 years. The design of the mortgage isn't what creates the quicker amortization it is the extra full payment you make each year (13 vs. 12).

If you had a 7% 30 year and decided to make it a bi-weekly, using a $250,000 loan for the example you would be spending about $21,700 a year in payments and lower the amortization to 23.33 years.

A 20 year fixed for the same amount @ 5.75% would have you paying about $21,000 a year in payments (12) and have you finished paying off the loan over 3 years faster.

Although option arms with the 1% teaser rate are advertised as the loans that give you four choices each month , the interest only loans work much better. You have two choices each month: interest only or any amortization you choose, (Even if you chose a 50 year amortization you would be paying more than just interest only, so it would be allowed). The advantage of an interest only loan is that when ever you pay down principal the interest only payment is lowered because the interest you pay is on the remaining balance. Start with an interest only loan of $250,000 @ 6% and pay off $21,000 in the first year. At the beginning of the year the interest only payment would be $1250 a month and at the end it would have dropped to $1145 a month.(6% of $229,000 paid monthly).

Now let's look at the option arm. An option arm is a loan with a teaser rate, generally about 1%, and an interest rate made up of a margin and an index. The indexes are usually libor or the monthly treasury average which are short term rates and relate to the federal funds rate of 5.25%. You add the index (5.25%) to the margin, which is short for profit margin and is usually at least 2% but in many cases as high as 3% to get your actual interest rate: 7.25%to 8.25%. It is pretty easy to see why your option arm is negatively amortizing (rising balance on your mortgage instead of falling balance) because the spread is too large. 1% fully amortized cannot equal interest only at 7.25% to 8.25%. The amount that isn't covered is added to your balance each month and carries the same interest rate meaning you are paying interest on the interest you didn't pay.

The other options, interest only, 15 year or 30 year fixed are all based on the same margin and index giving you interest and payments that are too high. Interest only at 7.25% on a $250,000 loan is $1510.42 a month. A fully amortized 30 year on the same amount at 6% would have a payment of $1500 and you would be paying down the mortgage. The option arm doesn't make any sense!

A look at why a 15 year loan is probably the best loan is appropriate at this point. Comparing the payments of the 30 year fixed at 6% to the 15 year fixed at 5.5% on the $250,000 loan we have been talking about finds the 30 year at about 33% higher at $2042 a month versus the 30 year payment from above at $1500. Allow me to enter my prejudice toward the 15 year with a different notion about how to pay the loan.

You would pay it in two parts: the first part as the same as the 30 year which would be $1500 a month. The second part as an investment of $542 a month.

This investment is guaranteed and is also tax free accumulation. You also have the entire payment available for investment for the next 15 years. If you only accumulate the $542 amount for the next 15 years without interest it would be $97,560. If you used the 30 year payment, $1500, your balance in 15 years without interest would be $270,000 and if you used the $2042 per month the amount over 180 months would be $367,500 without interest.

This analysis of the various ways to pay your mortgage should give you some food for thought as to whether you have the right mortgage, whether you are paying your mortgage in a way that is most beneficial to you or whether both need to be changed. If your mortgage and the method you pay it are working for you and your interest rate is at the current mortgage then you are way ahead of the game. If not then it is time for you to reconsider and take the steps that will be financially rewarding for you.