The Best Way to Make Extra Principal Payments on Your Mortgage?

If your like me you make extra principal payments to your mortgage.

My wife and I are currently focusing on prepaying one of our mortgages with the highest interest rate. The mortgage is a 30yr fixed @ 6.5% administered by Chase on House #2 (rental). We currently contribute an extra $75/mo for additional principal payments taken out with each monthly auto-debit mortgage payment on the mortgage as well as make additional separate principal payments periodically.

After a period of time I began to wonder how Chase calculates the monthly interest payment. No matter when I contributed a lump sum (of say $1,000) it seemed as though the amount interest calculated on the next monthly mortgage payment wasn't changing as much when principal payments were made early in the month. I was expecting a sharper drop in the amount of interest paid if I made an extra principal payment at the beginning of the month versus the end of the month (ie. 30days of interest savings). I decided to dig into this a bit to see exactly how this was working.

First I started digging through my mortgage closing papers looking for an explanation of how the mortgage interest was calculated. I couldn't find much other than interested appeared to be calculated monthly, not daily like I was expecting. That means the interest portion of my mortgage payment is calculated based on a balance once per month, not based on a daily balance apparently like my equity line.

So I tried to validate this with recent transactions on my mortgage. Here is a table of the transaction history on my House #2 Chase Mortgage:

Date

Description

Payment

Principal

Interest

Ending Loan Balance

7/7/2009

PRINCIPAL PAYMENT

$75.00

$75.00

$0.00

$89,534.21

7/7/2009

PAYMENT

$817.45

$171.04

$486.31

$89,609.21

6/26/2009

PRINCIPAL PAYMENT

$6,500.00

$6,500.00

$0.00

$89,780.25

6/2/2009

PRINCIPAL PAYMENT

$100.00

$100.00

$0.00

$96,280.25

6/1/2009

PRINCIPAL PAYMENT

$75.00

$75.00

$0.00

$96,380.25

6/1/2009

PAYMENT

$817.45

$134.16

$523.19

$96,455.25

5/27/2009

PRINCIPAL PAYMENT

$100.00

$100.00

$0.00

$96,589.41

5/1/2009

PRINCIPAL PAYMENT

$75.00

$75.00

$0.00

$96,689.41

5/1/2009

PAYMENT

$809.24

$132.49

$524.86

$96,764.41

4/27/2009

PRINCIPAL PAYMENT

$1,500.00

$1,500.00

$0.00

$96,896.90

4/17/2009

PRINCIPAL PAYMENT

$100.00

$100.00

$0.00

$98,396.90

4/1/2009

PRINCIPAL PAYMENT

$75.00

$75.00

$0.00

$98,496.90

4/1/2009

PAYMENT

$809.24

$122.75

$534.60

$98,571.90

So then I studied these Loan Balance after each transaction and calculated an interest payment based on that loan balance using a monthly interest calculation. Annual Interest Rate = 6.5% / 12 (monthly payments) = 0.54167% Monthly Interest Rate. The Calculate Monthly Interest Colum is equal to the ending loan balance x 0.54167%.

Date

Description

Payment

Interest

Loan Balance

Calculated Monthly Interest

7/7/2009

PRINCIPAL PAYMENT

$75.00

$0.00

$89,534.21

$484.98

7/7/2009

PAYMENT

$817.45

$486.31

$89,609.21

$485.39

6/26/2009

PRINCIPAL PAYMENT

$6,500.00

$0.00

$89,780.25

$486.31

6/2/2009

PRINCIPAL PAYMENT

$100.00

$0.00

$96,280.25

$521.52

6/1/2009

PRINCIPAL PAYMENT

$75.00

$0.00

$96,380.25

$522.06

6/1/2009

PAYMENT

$817.45

$523.19

$96,455.25

$522.47

5/27/2009

PRINCIPAL PAYMENT

$100.00

$0.00

$96,589.41

$523.20

5/1/2009

PRINCIPAL PAYMENT

$75.00

$0.00

$96,689.41

$523.74

5/1/2009

PAYMENT

$809.24

$524.86

$96,764.41

$524.14

4/27/2009

PRINCIPAL PAYMENT

$1,500.00

$0.00

$96,896.90

$524.86

4/17/2009

PRINCIPAL PAYMENT

$100.00

$0.00

$98,396.90

$532.99

4/1/2009

PRINCIPAL PAYMENT

$75.00

$0.00

$98,496.90

$533.53

4/1/2009

PAYMENT

$809.24

$534.60

$98,571.90

$533.93

Its readily apparent that the monthly interest calculated is based on the ending balance of after the last transaction of the month before the mortgage payment is applied. I have seen no evidence of adjustments made to the loan balance for principal payments that are applied anytime before the time that the interest is calcaulated. Perhaps these adjustments are made at the time of payoff.

This means a couple things to me:
1) Im wasting a month's worth of interest on that additional monthly principal payments I am making with my mortgage payment. Rather that contributing the extra $75 principal with my mortgage payment I should be making that payment right before the next mortgage payment and earning interest on that money somewhere else for the month.
2) For seperate additional principal payments I see no advantage to sending in a principal payment before the last possible day of the month - might as well earn interest elsewhere because the mortgage company treats them the same regardless of whether they are received on the 1st or the 30th of the same month.

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Comments (11)


2Mil,
Nice analysis but why bother? The current best MM rate is

Why Bother

Have you calculated how your LT rate of return on investments compares to the cost of your mortgage dollars? It seems to me that you should only prepay your mortgage if that inv RoR after taxes is lower than the cost of the mortgage after taxes. Ideally, there should also be a risk adjustment factor, but that's a little more dificult to implement.

In any event, if you were able to lock at today's rock-bottom mortgage rates, it would probably be wise to not prepay your mortgage, investing it instead. In your morgage rate is higher, a refi, even down the road, may be preferred to a pre-payment.

I tend to want to pay off my loans as slowly as possible. This preserves my liquid capital and my tax break from mortgage interest. You never know what tomorrow's liquidity situation will be.

Shouldn't the monthly interest rate be 0.5262% {i.e. (1.065)^(1/12)}

Good analysis of the situation. When I first got my mortage I also thought that the interest was calculated daily, so I would always pay my payment way early. I soon discovered that it was calculated by simple interest and paying my mortage payment early was a "waste". I now make my payment on the last day of the month.

JW

@Math Nerd:
i believe he quoted APR to us (as most loans are advertised to customers on an APR basis), so his calculation was correct. if he had quoted APY to us, you'd be correct.

You found out a not-so-secret nasty trick of the banks. Pay 15 days early, pay the last day of the grace period, no difference. Yes, it's a great idea to keep sending that addition to principal each month. In an effort to combat the scam from UFirst (The Money Merge Account) I created a flexible spreadsheet, downloadable from my site, no cost, no email, no issue, which can help you see exactly how your final payment gets pulled in with every dollar extra you prepay.

(Minor typo, "your" should be "you are" or "you're" in your first line.)
Good post.
Joe

Finally someone doing their own thinking! This is a great blog and I'll be reading more. I'm doing payments to principal and was trying to decide the best strategy of when to apply them and I want to make sure I'm following. I'm with chase as well, and I think you're saying that the calculation of how much of your payment applies to principal is calculated based on balance due @ time of mortgage payment. So doesn't that mean you should just make your extra principal payment immediately before the monthly payment? Also, do your extra payments post before the calculation if you do the transactions back to back on the same day, or are you spacing them a day apart or something similar?

Jarris,

Yes - at this point I believe its a simple interest calculation - the monthly interest is calculate with your balance at the time of your monthly payment. As a result I make any additional principal payments just 1-2 in advance of my monthly payment.

Good analysis and correct. You need to watch how Chase applies that extra principal very closely. Have your own amortization schedule and make sure they are posting your extra principal payment before your regular payment. I have caught both Chase and BofA, suspensing principal payments until after they have applied the regular payment, even when the principal payment arrived days earlier. I have also caught BofA taking my extra principal payments and making three or four regular payments months ahead of schedule. Both of these dirty tricks reduce the amount of your pricipal reduction and increase the portion or your payment they put to interest income for them. I'm currently in an email battle with Chase over the timing of my August principal and regular payments. I will win.

Also recommend doing all these activities electronically via their own web site, chase.com. Creates in indisputable trail of the timing and application of the money flow.

I wanted to make one full mortgage payment and was wondering if anyone knows when the most beneficial time would be. I refinanced August 13, 2010, so it will be a year this August. Someone told me making a full mortgage payment in month 12 of the loan, which would be August 2011, is the most beneficial. If that is true, it seems it would be the most beneficial to make the payment at the beginning of the month before my monthly payment is posted?? Does anyone have any thoughts? I am also with Chase.

This was handy info. I am going to make a big principal payment, and was about to do it at the first of the month. Doing it on the last day will make me quite a few bucks (well, at least enough for tank of gas :)

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