Forum Friends - In the simplest terms can you help me understand what I cannot get my brain wrapped around please. I understand "Simple Interest" so let's skip this lesson plan but you can use it as a reference if needed.

Question 1 - I understand on a home mortgage the bank gets to collect a lot more interest during the early life of the loan - Is this the "Rule of 78" and if so how is this calculated (I know that 1+2+3+...thru 12 = 78 but this does not help me understand how this is calculated. I know there are mortgage calculators on line - I just want to understand how it is calculated)?

Two months ago I made a LARGE principal payment on my home mortgage in addition to the monthly payment I make. I asked the bank to apply the entire "additional" lump payment" (separate from my regular house payment) amount to my home mortgage principal and they did - but even after reducing my principal balance by 30% of my remaining loan balance, the bank continues to follow their original "interest" calculations just like I had not reduced my principle balance by 30%. What I saying here is the bank continues to pull the same amount of interest from each monthly payment based on the original loan amortization schedule. I "thought" by paying down the loan principle the bank would not be able to collect as much interest each month - but for the past two months they have.....

Question 2 - Is this allowable and/or is there anything I can do to get the interest they are pulling from my monthly payments reduced since the total loan principle is now 30% less than it was two months ago?

Thanks Mark

You need to talk to your bank. Anytime I’ve ever made an additional payment on principal, the interest has always been calculated on the new, lower amount of principal owed. The total payment amount remained the same, but the amount of each payment going towards principal increased and the amount going toward interest decreased.

Answer to question two;

I did the same thing. I made a 20% payment to the principal. Prior to this I had contacted the mortgage company and told them what I was doing. There was a $200 recalculation fee. My next monthly payment was considerably less, and interest was calculated off the new principal balance.

You may have to ask and possibly pay a fee to have your loan recalculated.

I'll try


You signed a loan agreement for To finance $XXXXXX and pay $XXX a month for however many years, that payment amount won't change until it's paid off. The amount of interest you pay on that payment will go down as the loan balance goes down, paying more to principal. The only way the payment changes is Escrow going up or down.

The Rule of 78 is you owe all interest even if you paid it off the next month

Thanks guys for your replies. I will contact the bank’s mortgage department tomorrow. Mark

Something is not correct.

First off the rule of 78s is illegal on loans greater than 61 months in the US since the 1990s. If this loan is longer this does not apply.

They should be calculating the interest due monthly. simple formula. interest rate divided by 12 x outstanding principle.

Your payment should stay the same the portion to principle and interest should change.

It is a simple calculation, they may have not credited your principle paydown correctly.

quote:

Originally posted by BigSwede:
I'll try


You signed a loan agreement for To finance $XXXXXX and pay $XXX a month for however many years, that payment amount won't change until it's paid off. The amount of interest you pay on that payment will go down as the loan balance goes down, paying more to principal. The only way the payment changes is Escrow going up or down.

The Rule of 78 is you owe all interest even if you paid it off the next month

BigSwede - Thanks for the simplified explanation related to the Rule of 78. I am assuming that mortgage loans would not be a loan utilizing the Rule of 78 guidelines. Thanks again for your reply. Mark

Sig2392 - I should have provided more detail earlier. This is a fixed conventional home mortgage at 4.5% interest on $137k for 30 years. Monthly payment is $694 and change and never changes.

I was not sure if my loan was following the Rule of 78 guidelines - reading what you posted it must not be….Sorry for my confusing summary earlier and thanks for your reply. Mark

I just calculated (on line mortgage calculator) and by making a one time payment like I did my monthly interest should go down, based on where I am in my loan, from about $385 a month to $252 a month so I will be calling the bank tomorrow.

Even if they charge a small fee to recalculate the loan it should pay for itself real dang fast considering the interest saved will be slightly more than $130.00 a month…..

Thanks again to all of you who responded….Mark

The payment should be $694.16 and won't change regardless of how much extra principal you pay. However the ratio of principal to interest on each payment should increase if you paid down the balance.

To calculate the payment use the payment function in Excel. =PMT(rate, nper, pv)

To see how much interest on each payment there should be, multiply the beginning principal balance for the month by the interest rate.

Take the difference between the total amount of the payment and the amount of the interest and you have the amount going towards principal each month.

Read your loan documents.

If you are in the first three years of the loan, you may have triggered a prepayment penalty.

Only if it is in your documents. Not all loans have prepayment penalties.

If it is not there, or you are past the first three years there should be not penalties or fees for paying down the mortgage.

quote:

Originally posted by BigSwede:
The Rule of 78 is you owe all interest even if you paid it off the next month

Not true. The rule of 78 is also called 'sum of the digits'. On a 12 month loan, if you add months 1-12 you get 78. (on a 2 year loan you get 300). The first month of that loan, you will pay 12/78 of the total precomputed interest. in the second 11/78. The final month you will pay 1/78 of the interest. What this does, is load most of the interest in the front of the loan.

This method was very popular in the 70's and 80's by finance companies. I have never seen the 78 thing used on a residential home loan.

This method is/was also used in computing refunds on insurance policies. The insurer earned most of the premium in the front 1/3 of the policy. It was not at all linear.

Rule of 78s: it is a method of calculating interest similar to simple interest, but it is done at the time of loan initiation rather than calculated periodically against the outstanding loan balance. The interest paid over the life of the loan is the same total as with simple interest calculations (assuming that payments are made as agreed), but a higher proportion of the interest is paid in the early years of the loan even more so than with simple interest. Another way of looking at this is that with a rule of 78s loan, the interest owed on a loan is precomputed at the time of loan issuance rather than computed for each payment period. This also affects early payout, in that with rule of 78s, an early payout will result in more interest being paid to the lender than with a simple interest loan.

One of the first amortization tables I did (in Visicalc no less) was of a comparison between a simple interest loan and an equivalent rule of 78s loan. The result was not hugely different monetarily (unless the consequences of early payout were considered).

This is also probably why you are not seeing a significant reduction in the interest portion of the monthly payment. You might want to carefully read the fine print in your original loan documents to confirm what you agreed to at the issuance of the loan. It may be that the reduced principal kicks in to the calculation at a year boundary, or some other milestone for re-calculation. Or, it may be that you agreed to pay the entire pre-calculated amount of interest and an early partial payment of principal does not modify this factor. Or, it could be that the "unearned interest" the lender receives in the event of an early partial payment of principal does not have to be refunded until the entire principal has been paid off. Harsh, yes, but contracts can be that way. Your lender may be able to suggest other options, such as refinancing into a new mortgage, so as to pay off the old one in full. But if they have you by the balls, don't expect that they might not twist a little to get your full attention.

There may be some legal aspects to this, I believe the use of the Rule of 78s is prohibited in some jurisdictions, and for some circumstances (like for loans with a repayment period exceeding some number of months).

You need to call your bank and ask them if they will “recast” the loan. So it amortizes over the remaining term of 20, 23, 25 or or whatever years you have left to stay on the original timeline but lower your payment. They may refuse especially if the loan has been sold. Your note almost certainly says they will accept extra payment a but is silent on recasting. If they don’t recast it, all you have done is shorten the term by x years. And the original payment in the note will apply and just pay off in full much sooner.

Assumes we are discussing a fixed term loan. Also assumes your loan is still held by the original lender. If loan is sold, the current servicer will have little to no control.

Making a lump sum payment on a conventional fixed-rate mortgage will not lower the monthly payment by lowing the interest rate. It will however significantly reduce the term of the loan by applying the additional payment to the principle. Fewer payments translate into less interest paid over the life of the loan. In your example, instead of paying 4.5% interest over 360 monthly payments, you will be paying 4.5% over 'x' monthly payments. The total savings over the life of the loan will be enormous.

If this is a conventional, conforming loan, meaning that it can be sold to Fannie Mae or Freddie Mac, it will behave exactly as hjs157 describes. If you paid down 33% of the principal in the first year of your mortgage, you just eliminated 180 payments and saved yourself around $45,000 in interest payments over the life of the loan.

Your loan-to-value ratio is now well under 80%. If Fannie or Freddie own your mortgage, your loan is now such a good risk that they no longer require you to pay for Private Mortage Insurange (PMI). Contact your lender and tell them to drop their PMI policy. That will save you some money.

quote:

Originally posted by Beancooker:
Answer to question two;

I did the same thing. I made a 20% payment to the principal. Prior to this I had contacted the mortgage company and told them what I was doing. There was a $200 recalculation fee. My next monthly payment was considerably less, and interest was calculated off the new principal balance.

You may have to ask and possibly pay a fee to have your loan recalculated.

Except that standard mortgages have a clause that says "no prepayment penalty." If there's no penalty for prepaying the loan, then there shouldn't be a fee to "recalculate" the loan; it's not like the bank is recording the payment transactions on a paper ledger using paper and pencil. The bank should have been able to point out the applicable clause in your mortgage document as that controls what affects or doesn't affect the mortgage terms.

quote:

Originally posted by ElToro:
You need to call your bank and ask them if they will “recast” the loan. So it amortizes over the remaining term of 20, 23, 25 or or whatever years you have left to stay on the original timeline but lower your payment. They may refuse especially if the loan has been sold. Your note almost certainly says they will accept extra payment a but is silent on recasting. If they don’t recast it, all you have done is shorten the term by x years. And the original payment in the note will apply and just pay off in full much sooner.

Assumes we are discussing a fixed term loan. Also assumes your loan is still held by the original lender. If loan is sold, the current servicer will have little to no control.

You don't want to recast the loan for the remaining years. The point of increasing principal payments is to lower total interest paid and to end the mortgage earlier. Recasting will result in lower monthly payments at the same interest rate and same ending date. What purpose would that serve? The person demonstrably can handle the current monthly payments; otherwise, he wouldn't have made an incremental principal payment so it's not like he needs the cash flow. If he needed the cash flow, he could have just not paid the extra principal payment and kept the cash.

You need to read your closing documents, specifically the contract. In there, most now are simple interest with no prepayment penalty. You need to be sure they applied this as extra principal, not just making a regular payment early.

I bought my first home in 1981 and even back then it was simple interest. Not saying yours couldn’t be different but I haven’t heard of anyone I know having a rule of 78 loan for decades.

If your goal is to pay off your loan early and be debt free, then do not have the monthly payments recalculated and the payment each month reduced.
By continuing to pay the original monthly payment amount after a prepayment of principal, you are effective paying a bit more principal each month that originally in the contract, thereby paying even more principal each month. That speeds up the end date even more.
Being mortgage free is a great feeling.