Understanding How Most Mortgage Loans Amortize

Why do mortage payments paid extra go to the end leaving the larger interest being paid and a small amt at the end being paid. Why can't you pay your mortage ahead example if I wanted to pay this month and next two,why is it not allowed?

1 Answer

The answer to this question requires an understanding of how most mortgage loans amortize. As an example let's take a fixed rate mortgage loan of $100,000 at 6% interest with a payment of $600/month. This loan will pay off in about 360 payments or 30 years. The loan requires a payment once per month due on the first and the agreement with the borrower is that they can prepay in whole or in part without penalty. Note that a 6% yearly rate equals a monthly interest of 6% divided by 12 or 0.5%.

To calculate the interest earned by the lender, the loan balance is multiplied by the monthly interest rate. When the first $600 payment is due on this loan the interest due is $500 ($100,000 X 0.5%). That leaves $100 of the payment which is applied to the $100,000 principal balance reducing it to $99,900. The next payment of $600 would have 0.5% of $99,900 or $499.50 of interest due with the remaining $100.50 applied to principal. At first it seems that it will take forever to payoff the balance, but if this calculation is repeated approximately 360 times the principal balance will be reduced to $0 and the loan will be paid off in 30 years. As each succesive payment is made the principal balance gets smaller and therefore the amount of interest owed for that month becomes smaller. Therefore the amount of the payment that goes to pay interest is reduced increasing the amount of each payment that is applied to principal.

While the borrower is required to pay at least $600 per month the borrower may elect to pay more than the minimum payment to pay the loan off quicker. Since the borrower may prepay in whole or in part without penalty, any extra paid above the $600 required payment is applied to the principal. For example if in our example the borrower sends in a payment of $30,500 with the very first payment, the principal will be reduced from $100,000 to $70,000. As we calculated above, the interest due on the first payment is $500. The remaining $30,000 is applied to the principal leaving a $70,000 balance. The interest due on the next payment will be 0.50% of $70,000 or $350. If the borrower makes the minimum required payment of $600 on the next payment due, the remaining $250 left after the interest is paid is applied to the principal leaving a balance of $69,650. If the borrower continues to pay the minimum required payment of $600 the loan will have about 176 payments to make before the loan is paid off.

Extra payments do not actually "go to the end." They are taken off of the balance due and interest is calculated on the remaining balance. Once an extra principal payment is made, the borrower never pays interest on that amount again. This brings us to the question, "Why can't you pay your mortgage ahead?" This is because the agreement between the lender and the borrower is that the borrower can prepay the loan without a penalty. If the borrower sends in an extra payment, the extra principal payment must be be applied to the principal and the interest on the next payment due must be calculated on the resulting lower balance. The lender does not have the option to wait and apply the payments in the future and the borrower does not have the option to "skip" payments.