Advance payments on your mortgage

Last week, I wrote about mortgage repayment as a type of investment. This one is focused on payment mechanics.

Question: Will I save money if I make regular monthly payments early?

Answer: No, paying early merely allows the firm servicing your loan to earn interest on your money until your payment is due.

On a standard mortgage, the scheduled payment is due the first of the month, but there is a grace period of 10 to 15 days during which the payment can be made and will be credited as if it were paid on the first. If payment is received after the grace period, a late fee is imposed, but payments received before the due date are not rewarded.

An exception is the simple interest mortgage, on which interest accrues daily. On these mortgages, every day of delay in making the payment increases the interest cost, and the earlier you pay, the more interest you save.

Q: How do I know if my mortgage is simple interest?

A: Your note should say that interest accrues daily, but it might not. A sure sign is that the monthly payment on such a mortgage varies month to month. If your monthly payment is always the same, you do not have this type of mortgage.

Q: What is the best time of the month to make an extra payment?

A: The last day of the month for which the lender will apply the payment to the current balance.

If you include the extra payment with your scheduled payment and pay within the grace period, the extra payment will be applied to the current balance. If you make the extra payment after the grace period, it might be applied to the current balance, or it might not be credited until the following month, depending on the systems and policies of the servicer.

Find out where the servicer's cutoff is for crediting payments in the current month.

Q: If I make a large extra payment, will my future scheduled payments be lower?

A: On a fixed-rate mortgage, the scheduled payment is not affected by the extra payment. You merely pay down the balance faster. However, at your request and for a fee, some servicers will reduce the payment to the amount that will amortize over the remaining term. If you want to do this, arrange it beforehand.

On an adjustable-rate mortgage, the scheduled payment remains the same until the next rate adjustment. At that point, the payment is recalculated based on the reduced balance, the new rate, and the original term. Unless a rate increase offsets it, the payment drops.

Q: What is the difference between an extra payment and an advance payment?

A: An extra payment reduces the loan balance. An advance payment is the scheduled payment made before the due date - an interest-free loan to the servicing agent for the period until the payment comes due. Advance payments serve no purpose for borrowers except for the peace of mind of knowing they are ahead of the game.

Q: Aren't advance payments necessary if you plan to be out of touch?

A: No. I spent a year traveling and never made any advance payments on my mortgage. Before I left, I gave my mortgage lender 12 checks dated on the first day of 12 consecutive months. These were not advance payments because the checks would not clear before those dates.

Q: Can I pay off an adjustable-rate mortgage early?

A: It's difficult but doable if you know how. The reason is that the extra principal payments designed to shorten the term reduce the scheduled monthly payment at each rate adjustment, because the new payment is calculated to pay off over the original term. To offset the decline in the scheduled payment, the borrower must increase the extra payment at every rate adjustment date.

This is a pain, but I now have a calculator at my website (http://goo.gl/oAbGGA) that eases the pain substantially.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. http://www.mtgprofessor.com