Mortgages Analyzed
Mortgages Analyzed
Mortgages Analyzed
 
Prepayment

What is Prepayment?

Prepayment

Prepayment occurs when an amount greater than the regularly scheduled principal payment is made which reduces the unpaid principal balance of a loan. In other words, it refers to amounts paid over and above the required monthly payment that are applied towards principal balance. Monthly payment includes the principal and interest portion and may additionally include escrow payment, PMI premium, and other fees. Any amount paid above the required monthly payment is applied to the principal, based on the terms of the note. Generally, the additional payment is first applied to the outstanding fees and escrow shortages, followed by accrued interest, and finally towards the principal. Prepayments can be partial or full prepayment.

Before scheduling any additional payments, you should call your lender to understand how the payment will be applied.

Source :www.MortgagesAnalyzed.com

Partial Prepayment

Partial prepayment refers to the amounts paid over and above the required monthly payment that are applied towards principal balance, but are not large enough to completely pay off the loan. Partial prepayment reduces the unpaid principal balance but does not cause the loan to be fully paid off.

One Time Prepayment

One Time Prepayment is single amount above the monthly payment that is applied to principal. It is an ad hoc prepayment which may be made along with the monthly payment or at any other time. For example, it occurs when you apply your yearly bonus towards the loan repayment.

Recurring Prepayments

Recurring prepayments are scheduled additional payments that are made periodically and applied towards the principal of the loan. For example, you may pay an additional $100 with each monthly payment that is applied towards principal.

Full Prepayment

Full prepayment refers to the payment made prior to the end of the loan term that will completely pay off the entire loan obligation. In other words, full prepayment occurs when the entire balance of the loan is paid prior to the due date. For example, a payment in the seventh year that will completely pay off the 30 year loan is a full prepayment. Full prepayment can occur as a result of the sale of the property, a refinance of the existing mortgage loan, or a full loan payoff. The amount required to pay off the entire loan obligation as of a particular date is known as the payoff amount.

Source :www.MortgagesAnalyzed.com

Prepayment Penalties

Prepayment penalty refers to the fees that are charged by the lender when the borrower makes a principal prepayment during the prepayment penalty period. The prepayment penalty period (PPP) is the time period during which the prepayment penalty can be levied. Typically, the prepayment penalty period ranges from 6 months to more than 3 years after the loan has been closed.

The prepayment penalty compensates the lender for loss of income that would have been made had the principal payment made. The amount of prepayment depends on the type of loan and the terms described in the note. Typically, the penalty amount is equal to six months interest payment.

Prepayment penalties are becoming increasingly uncommon due to various regulatory requirements.

The two types of prepayment penalties are:

  1. Hard Prepayment Penalty: Hard prepayment penalty requires the borrower to pay a penalty amount when a loan is paid off because the loan is refinanced or the property is sold. Prepayment penalty is charged whenever prepayment occurs, irrespective of the reason for the prepayment.
  2. Soft Prepayment Penalty: Soft prepayment penalty requires the borrower to pay a penalty amount when a loan is paid off because the loan is refinanced only. Prepayment penalty is not charged if the borrower sells the property.
Source :www.MortgagesAnalyzed.com

How Does Prepayments Affect Amortization

Additional principal payments may reduce the loan term, or reduce the monthly payment, or both. It depends on the terms of loan product that are specified in the mortgage note. Common scenarios are discussed below.

 

Fixed Rate Mortgages – Reduces Term

Additional principal payments reduce the loan term in case of fixed rate mortgages (FRM). The monthly payment is not recalculated based on the reduced principal balance and you continue to make the same monthly payment that was set when you took the initial loan.

Illustrative Example

Assume you obtained a 30 year mortgage loan of $100,000 at 6% interest on Jan 1, 2010. Assume after the end of first year you pay an additional amount of $5,000.

In this case, the monthly payment is $599.55. At the end of one year, on Jan 1, 2011, when you have made 12 payments of $599.55, you have an outstanding balance of $98,771.99. The additional principal payment of $5,000 will reduce this balance to $93,771.99. The monthly payment is not recalculated based on the reduced principal balance; instead, you continue to pay the same monthly payment of $599.55 that was set up initially. However, because of prepayment, your monthly payment will be higher that what would be required to amortize the remaining loan in the full 30 year term. As a result, the loan is paid off earlier on 7/1/2037, which is 42 months prior to the maturity date of 1/1/2040.

Source :www.MortgagesAnalyzed.com
  With Prepayment Without Prepayment
Origination date Jan 1, 2010 Jan 1, 2010
First payment date Feb 1, 2010 Feb 1, 2010
Initial payment amount $599.55 $599.55
Prepayment on 1/1/2011 $5,000 N.A.
Payment from 2/1/2011 $599.55 $599.55
Last payment date 7/1/2036 1/1/2040
Loan paid in 318 Months 360 Months
 

Adjustable Rate Mortgages – Reduces Payment

In most ARM loans, the monthly payment is recalculated at each rate adjustment based on the outstanding principal balance. Additional principal payments reduce the principal balance which in-turn reduces the monthly payment amount while having little effect on loan term. The only time loan term is reduced is when the prepayments are made after the last rate adjustment on the loan.

Illustrative Example

Assume you obtained a 1 Year ARM loan of $100,000 at 6% interest on Jan 1, 2010. Assume after the end of first year you pay an additional amount of $5,000. The interest rate adjusts yearly. Assume the interest rate on Jan 1, 2011 stays the same as 6% and on Jan 1, 2012 and beyond is 7%.

In this case, the monthly payment at the beginning of the loan is $599.55. This will remain constant for the first year. At the end of one year, on Jan 1, 2011, when you have made 12 payments of $599.55, you have an outstanding balance of $98,771.99. The additional principal payment of $5,000 will reduce this balance to $93,771.99. On this date the loan payment is recalculated to allow for rate adjustment. At this time the new rate is still 6%. Using the outstanding balance of $93,771.99 the new payment will become $569.20. This payment amount will remain constant for the next 12 months. As you can see the prepayment reduced the monthly payment by $30.35, even though the rate is the same. The loan term remains the same since the monthly payment amount calculated using remaining term and outstanding balance.

At the end of 2 years, on Jan 1, 2012 the interest adjusts to 7%. The new payment now will be $628.87.

Source :www.MortgagesAnalyzed.com

Summary and Comparison,

  With Prepayment Without Prepayment
Origination date Jan 1, 2010 Jan 1, 2010
First payment date Feb 1, 2010 Feb 1, 2010
Initial payment amount $599.55 $599.55
Prepayment on 1/1/2011 $5,000 N.A.
Rate Change on 1/1/2011 6% 6%
Payment from 2/1/2011 $569.20 $599.55
Rate Change on 1/1/2012 7% 7%
Payment from 2/1/2012 $628.87 $662.40
Last payment date 1/1/2040 1/1/2040
Loan paid in 360 Months 360 Months

What if interest rate was higher at 8% on Jan 1, 2011?

In this case, with the prepayment of $5,000, the new payment from Feb 1, 2011 will be $693.86, which is $94.31 higher than previous month. If the prepayment was not made, the payment would have been $730.86.

Prepayment After Last Rate Adjustment

Prepayment made after the last interest rate adjustment will reduce the remaining loan term.

 

Payment during Interest Only Period

Prepayments made during the initial interest only term will reduce the interest payment during interest only term and the payment during fully amortizing period.

Illustrative Example

Assume you obtained a 30 year mortgage loan of $100,000 at 6% interest on Jan 1, 2010. The loan has a 5 year interest only term. Assume after the end of first year you pay an additional amount of $5,000.

In this case, the monthly payment is $500. At the end of one year, on Jan 1, 2011, when you have made 12 interest only payments of $500, you have an outstanding balance of $100,000. The additional principal payment of $5,000 will reduce this balance to $95,000. The monthly payment is recalculated based on the reduced principal balance and you will pay $475.00 for subsequent periods. At the end of 5 years, when the interest only period ends, the payment will be $612.09. The loan is still paid off on its original maturity date of 1/1/2040.

Source :www.MortgagesAnalyzed.com

Summary and Comparison,

  With Prepayment Without Prepayment
Origination date Jan 1, 2010 Jan 1, 2010
First payment date Feb 1, 2010 Feb 1, 2010
Initial payment amount $500.00 $500.00
Prepayment on 1/1/2011 $5,000 N.A.
Payment from 2/1/2011 $475 $500
Payment from 2/1/2015 (end on IO term) $612.09 $644.30
Last payment date 1/1/2040 1/1/2040
Loan paid in 360 Months 360 Months

Updated: Feb 25, 2016

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Prepayment is the amount paid above the monthly payment that is applied to principal
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