MORTGAGE PREPAYMENTS

WHY MAKE PREPAYMENTS?

Local lenders agree that making prepayments is an effective way of reducing debt. For example, a homeowner making regular monthly payments on a $100,000 loan will pay $54,000 in 5 years, but will have paid only $3,100 on the principal (his "equity"), not even enough to pay the Realtor's commission if the house is sold! However, if the owner had made a prepayment each month with the regular payment, in 5 years he would have over $8,300 in equity and save over $50,600 in interest. The owner also would have only 20 years remaining on the loan rather than 25.

In a typical 30-year fixed rate mortgage, when the owner makes only the regular monthly payment of $900 a month on a $100,000 loan, only 17% of the loan has been paid after 15 years, leaving the homeowner still owing about $83,000, plus interest. It will take more than 23 years before the portion going toward the principal is equal to the interest portion.

HOW TO MAKE PRE-PAYMENTS

The good news is that it isn't necessary to make "double" payments to prepay on a mortgage. You only have to pay the principal portion, which would be just over $40 at the start of a 30-year, $100,000 loan at about 10% interest. Each payment must be the exact amount of the principal for the month being prepaid, and the lender must be notified in writing that a prepayment is being made for which particular month on the amortization schedule".

Home buyers are furnished an amortization schedule at closing, but few people know how to use it. Sending a check that doesn't match the schedule will do little to reduce the interest and build equity. If the amount doesn't match, the lender will either take it off the principal at the end of the loan or may put it in a special lender's escrow account where it remains until the loan is paid.

PREPAYMENT PENALTIES AND "FIXED-RATE DISCOUNT PLANS"

Standard fixed-rate mortgages usually have no penalties for prepayment, but in 1996 some lenders began offering discount rates and fees if borrowers agree not to pay off their loan within the first several years — and to pay a cash penalty if they do. Here are some basics to help you assess whether "fixed-rate discount plans" (prepayment penalties) make sense for you.

Prepayment penalties of any kind on home loans are not legal in 6 states: Alabama, Alaska, New Mexico, Pennsylvania, Vermont, and West Virginia. Another dozen states impose restrictions of some type on lenders' ability to offer or require prepayment penalties. In states with no restrictions on penalties, consumers need to consider 4 key features of the deal they may be offered:

• The depth and type of price break. Price breaks of 1/8 to 1/4 percent on interest rates are typical, but go as high as 3/8 of a percent. Some lenders may offer to reduce points or other fees. Rather than charging 2 points at closing (each point is worth 1% of the loan amount), a lender may reduce it to 1 point in exchange for a prepayment penalty agreement. On a $200,000 loan, a discount of 1 point means $2,000 off your settlement sheet.
• The length of the no-prepayment "lock" period. Most programs run an average of 3 years, but in states with no restrictions lenders could ask for 5 years or more. For the borrower, the shorter the period the better, especially if the rate break is only 1/8 or 1/4 of a percent.
• How flexible is the no-prepayment deal? Some lenders allow early payoffs without a penalty when a borrower sells the house because of a job change or other reason. Only refinancings would be penalized by some lenders, while some would penalize prepayments for any reason.
• How stiff is the penalty? Generally lenders allow up to 20% prepayment without penalty, then hit you with a 2% fee on the 80% balance. Some plans can penalize you six months' interest or as high as a 3% loan balance charge.

Borrowers need to approach fixed-rate plan offers with a clear idea of the risks or rewards involved. Ask yourself:

• Are the odds strong that I'll stay with the house and loan for the years necessary to avoid the penalty?
• Is the price break sweet enough for me to risk a penalty?
• Do I want to lose the right to refinance if rates fall?

If the rewards outweigh the risks, perhaps you will decide to sacrifice your right to pay down your principle for several years. But remember, the earlier you form the habit of pre-paying, the more likely you are to continue it through the life of the loan.

Mortgage prepayments are an excellent way to reduce large mortgage debt to prepare for retirement. Presently, only 3 out of 100 people reach retirement financially independent, and of those three, two inherited the funds.

(Information was found in the Chattanooga Free Press: "Mortgage Prepayments Save Thousands," 1992; and "The Nation's Housing," 1996.)