Some loans allow payment to dip; others don’t

Many borrowers would like a mortgage on which the monthly payment would drop following a large payment to principal. They may have highly irregular income, or they may anticipate coming into a large sum of money from a bonus, bequest or insurance settlement.

Mortgages fall into four categories with regard to how responsive they are to this desire.

Standard fixed-rate mortgages are the least responsive. Next come standard adjustable rate mortgages, then any FRM or ARM with an interest-only option and, finally, the Home Ownership Accelerator, which is the most responsive.

* Fixed-rate mortgages: Extra payments will shorten the payoff period but do not affect the monthly payment. For ease of mathematics, if you borrow $100,000 for 30 years at 6%, your fully amortizing payment is $599.56.

Pay this amount every month, and you’ll pay off the loan in 30 years.

If you make an extra payment of $10,000 in month two, your payment in month three and all subsequent months remains $599.56. Your loan will be paid off in month 280, but until then, you’ll receive no payment relief.

Of course, the lender can always agree to modify the contract, and some will do it for a fee. In the previous example, the payment could be dropped to $539.48, which is the fully amortizing payment that will pay off the loan over the original 30 years.

* Adjustable-rate mortgages: With an ARM on which the borrower is making the fully amortizing payment, extra payments do change the monthly payment but not until the next rate adjustment. At that point, the payment is recalculated using the reduced balance and the original term.

Assume the $100,000, 6% loan is a three-year ARM, and that an extra payment of $10,000 is made in month two. The payment would remain at $599.56 through month 36. In month 37, assuming the rate stayed at 6%, the payment would drop to $525.62, the new fully amortizing payment amount over the original term.

On ARMs with longer initial rate periods, the drop in payment following an extra payment would be further delayed. On the popular five-year ARM, for example, the payment wouldn’t drop until month 61.

ARMs become more responsive after the initial rate period ends because rate and payment adjustments then occur more frequently – in most cases, every year or every 6 months.

* Mortgages with an interest-only option: If a loan is interest-only, the payment should decline in the month following an extra payment, whether the loan is fixed- or adjustable-rate. The interest-only payment on the $100,000 loan at 6% is $500. Following the payment of $10,000 in month two, the interest-only payment should drop to $450 in month three.

There are several caveats to this, however. One is that it doesn’t always work the way it should because not all servicing systems can handle it properly.

In some cases, the required new payment is properly calculated, but the new amount has not been communicated to the borrower. In other cases, the payment adjustment is delayed, sometimes for a year, sometimes for longer.

Of course, if it is an ARM, the payment will adjust when the rate adjusts. If it is fixed-rate, however, the payment may not change until the end of the interest-only period, which would be five or 10 years.

Whether the mortgage is FRM or ARM, after the end of the interest-only period, payment responsiveness disappears. After that, they are like any other FRM or ARM.

If you are contemplating an interest-only loan and find immediate payment adjustments in response to extra payments to be highly desirable, ask about them.

Don’t expect the subject to be volunteered by the loan officer or mortgage broker. They are not involved in loan servicing, and chances are they won’t know the answer and will have to ask. Make sure they do ask.

* Home Ownership Accelerator: The most responsive type of mortgage is the HOA, because it has no required payment, only a maximum balance. This loan combines all checking, home-loan and home-equity-line accounts into one account that automatically transfers all deposited cash against the loan balance each day. As long as the actual balance is lower than the maximum, the borrower need make no payment at all.

Starting in year 11, the maximum balance on an HOA falls by 1/240 of the balance at the end of year 10. If the balance at that time was $100,000, the maximum at the end of year 15 would be $75,000. If the borrower has made extra payments so that the actual balance at that time is only $72,000, and assuming the rate is 6%, he can skip eight payments before the balance gets to $75,000 and he has to start paying again.

HOA borrowers who make lump-sum payments to reduce the balance and want to reduce payments to the fully amortizing level can just go ahead and do it. Although the HOA servicer will not tell them what that new payment is (I am told this will be remedied at some point), it is very easy to find that number using my “Monthly Payment Calculator: Fixed-Rate Mortgages,” numbered 7a on my Mortgage Calculator page.

Because the HOA is an ARM that adjusts monthly, the fully amortizing payment will change a little every month, so borrowers who want to stay on track ought to repeat the exercise periodically.

Jack Guttentag is a syndicated columnist and professor of finance emeritus at the Wharton School of the University of Pennsylvania. Questions or comments can be left at www.mtgprofessor.com.