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Mortgage rates are down! It may be a good time to refinance, or learn the income you need to buy a median-priced home in the top 50 metro areas!

Mortgage rates are down! It may be a good time to refinance, or learn the income you need to buy a median-priced home in the top 50 metro areas!

Prepaying ARMs and Interest-Only Loans

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Most borrowers have fixed-rate mortgages, but other mortgage types wax and wane in popularity with the ebb and flow of interest rates. Two special cases to consider: Adjustable Rate Mortgages (ARMs) and Interest-Only home loans.

How you can benefit when you prepay an ARM

If you've got an ARM (or are considering taking one) and expect to prepay it, there are some differences you need to understand.

When you prepay a fixed-rate mortgage, whether conventional or FHA, the effect of doing so actually shortens the term of your loan, and much of your savings comes from not having to make any mortgage payments at the end of your term. This is because your fixed-rate loan has a fixed-amortization schedule set out at the beginning of your loan. Once set, the lender generally never revisits it.

Expert's note: In some cases when making significant prepayments on a fixed-rate mortgage loan (e.g. 25% or more of the outstanding balance in a single payment), a lender or servicer *may* agree to recast your mortgage. A recast can involve the lender re-amortizing your loan with the new lower balance over the remaining loan term. This has the effect of lowering your monthly payments, but of course does not shorten the term of your loan. Recasting is a voluntary action and is most commonly available for loans a lender holds in portfolio; some loans may not be eligible for a recast. Also, if they are willing to do this, a lender or servicer may charge a fee to recast your loan.

Prepaying your adjustable rate mortgage is slightly different than prepaying a fixed-rate loan. At regular intervals, your mortgage lender or servicer reviews the remaining outstanding balance on your ARM loan, calculates your coming period's interest rate, and informs you of your new rate and payment, which is based upon what term remains of your original term.

This means that, unlike a fixed-rate mortgage, prepaying an ARM doesn't really shorten the term by much, but these regular resets mean savings come in the form of monthly payments (and interest charges) that are lower than they would be absent you making any prepayments.

Prepaying an ARM

Here are two example prepayment scenarios and outcomes from prepaying an ARM.

Reducing monthly payments.

For example, if you took a 1-year ARM for $100,000 at an interest rate of 3%, your [monthly mortgage payment] would be $421.60 per month; at the end of the year, you would still owe $97,912.24 in principal. Let's say that your new interest rate for the coming year rises to 5%, with a remaining term of 29 years. Your payment would rise to $533.48 per month.

Instead of simply letting the entire balance be subject to a new, higher interest rate, you decide to prepay your loan with a $5,000 bonus right before the interest rate and payment adjustment is made. Your loan balance falls to $92,912.24, and at 5%, your monthly payment becomes only $506.24, more than $27 per month less than it would have been otherwise.

Because your payments for the next year are calculated on a single outstanding balance, you'll want to make your prepayment just before that rate and remaining-term "reset" is done. Otherwise, you might have to wait an entire year or more until the beneficial effects kick in, and you'll have paid interest during that time instead of avoiding it entirely.

Managing interest rate increases.

Prepaying your ARM can be a way to ameliorate a rising interest rate environment, helping to keep your required monthly payments lower than they would otherwise be, and even if you don't have a slug of cash to throw at your mortgage, making small regular monthly payments can offer some protection, too.

For example, let's say you took a $100,000 5/1 hybrid ARM five years ago at an interest rate of 4%. This means you have a fixed rate of 4% for the first five years of the loan and then change to an adjustable rate every year for the remainder of the mortgage term. Your initial payment is $477.42 per month. After five years, the rate is due to adjust, and your new interest rate is slated to be 6%.

Without making any prepayment at all, your remaining balance subject to the new 6% interest rate would be $90,447.20, and your monthly payment would rise to $582.75, an increase of $105.33 per month.

During the original fixed-rate loan period with a 4% interest rate, if you made a $50 per month prepayment starting at the first payment until the loan's first rate adjustment at month 61, you would have trimmed the balance subject to the rate adjustment down to $87,132.39 remaining principal. With a new interest rate of 6%, your new monthly payment would be $561.4 -- only $83.98 higher.

Sending the extra $50 per month for five years is now "paying you back" by saving you $21.35 per month for the next year and beyond, as future subsequent interest rate changes are also applied against a smaller-than-originally-expected remaining balance, even if you never make any additional prepayments.

Without explaining all the complicated math behind it, this is also akin to never making any prepayments and having a remaining balance of $90,447.20 after five years -- but rather than the loan reset with a new 6% interest rate, your $50 per month prepayment has given you the equivalent of a new interest rate of 5.61%. Of course, someone who didn't prepay his loan is stuck with the full lift to a 6% rate! In effect, you ameliorated a portion of the interest rate increase via prepayment, as your new required monthly payment is lower.

An oddity: Prepaying an interest-only mortgage

It might seem strange to select a mortgage that requires payments of only interest for a time and take steps to retire principal, too.

However, it's not a crazy idea. Interest-only (IO) mortgages are usually (although not always) ARMs, but even when they are fixed-rate products, paying down even some principal can help to offset a difficult and foreseeable payment shock down the road. Payment shocks can occur even if the mortgage is a fixed rate, as when the IO period ends, the borrower is left with a much shorter period over which to pay off the mortgage with fully-amortizing payments of both interest and principal, creating a so-called "payment spike."

For example, let's consider a 30-year fixed-rate mortgage of $100,000 with a 10-year interest only period at an interest rate of 4.5%. For the first 10 years, the interest-only payment is just $375, but remember that no principal is being retired. After the 120th payment, there are 240 payments (20 years) remaining of the original 30-year term and still a $100,000 principal amount; however, the payment now switches to a fully-amortizing one containing both principal and interest. With the same 4.5% interest rate, but only 20 years over which to repay the principal, the new payment would become $632.65, an increase of 68.7% -- a potentially painful jump.

Even if you didn't want to cover all the principal ($131.69) needed to make it a fully-amortizing loan in the first 10 years, any prepayments you make would mean a smaller loan balance when the reset to fully-amortizing payments comes. After the 10th year, a fully-amortizing loan as above would have a remaining balance of $80,089, so about 20% of the loan would have been retired. Sending even half of this amount -- $10,000 over 10 years (around $83 per month) -- means that the reset would see the required payment rise to $569.64, a somewhat less painful increase of "only" about 51.9%.

Curious about whether or not you should prepay your mortgage? Review our previous article: Should I prepay my mortgage?

Prepaying a mortgage is an important financial commitment and should be weighed against alternative investments. Read the next article: Prepay your mortgage or invest instead?