Lowering your payment depends on type of loan

Many would like a mortgage with the monthly payment dropping after a large payment to principal.

They may have highly irregular income, or they may anticipate coming into a large sum of money from a bonus, bequest or insurance settlement.

Mortgages fall into four categories with regard to how responsive they are to this need.

Standard fixed-rate mortgages (FRMs) are the least responsive.

Next come standard adjustable-rate mortgages (ARMs), then any FRM or ARM with an interest-only option, and finally the Home Ownership Accelerator (HOA), which is the most responsive.

• Fixed-rate mortgages: Extra payments on an FRM shorten the payoff period, but do not affect the monthly payment.

For example, if you borrow $100,000 for 30 years at 6 percent, your fully amortizing payment is $599.56.

Pay this amount every month, and you pay off the loan in 30 years.

If you make an extra payment of $10,000 in month two, your payment in month three and all subsequent months remains $599.56.

Your loan will pay off in month 280, rather than in month 360, but until then, you receive no payment relief.

Of course, the lender can always agree to modify the contract, and some will do it for a fee.

In the previous example, the payment could be dropped to $539.48, which is the fully amortizing payment that would pay off the loan over the original 30 years.

• Adjustable-rate mortgages: With an ARM on which the borrower is making the fully amortizing payment, extra payments do change the monthly payment, but not until the next rate adjustment.

At that point, the payment is recalculated using the reduced balance and the original term.

Assume the $100,000 6 percent loan is a three-year ARM, and that an extra payment of $10,000 is made in month two.

The payment would remain at $599.56 through month 36. In month 37, assuming the rate stayed at 6 percent, the payment would drop to $525.62 — the new fully amortizing payment over the original term.

On ARMs with longer initial-rate periods, the drop in payment following an extra payment would be further delayed. On the popular five-year ARM, for example, the payment wouldn't drop until month 61.

ARMs become more responsive after the initial rate period ends because rate and payment adjustments then occur more frequently — in most cases, every year or every six months.

• Mortgages with an interest-only option: If a loan is interest-only, the payment should decline in the month after an extra payment, whether the loan is fixed-rate or adjustable-rate.

The interest-only payment on the $100,000 loan at 6 percent is $500.

After the payment of $10,000 in month two, the interest-only payment should drop to $450 in month three.

There are several caveats, however. One is that it doesn't always work the way it should because not all servicing systems can handle it properly. In some cases, the required new payment is properly calculated, but the new amount has not been communicated to the borrower.

In other cases, the payment adjustment is delayed, sometimes for a year, sometimes for longer.

Of course, if it is an ARM, the payment will adjust when the rate adjusts.

If it is fixed-rate, however, the payment may not change until the end of the interest-only period, which would be five or 10 years.

Whether the mortgage is FRM or ARM, after the end of the interest-only period, payment responsiveness disappears. After that, they are like any other FRM or ARM.

If you are contemplating an interest-only loan and find immediate payment adjustments in response to extra payments a highly desirable feature, ask about it.

Don't expect loan officers or mortgage brokers to volunteer the information.

They are not involved in loan servicing, and the chances are that they don't know the answer and will have to ask. Make sure they do.

Homeownership accelerator (HOA): The most responsive type of mortgage is the HOA, because it has no required payment, only a maximum balance.

So long as the actual balance is lower than the maximum, the borrower need make no payment at all.

HOA borrowers who make lump-sum payments to reduce the balance and want to reduce payments to the fully amortizing level can just go ahead and do it.

While the HOA servicer will not tell them what that new payment is (I am told that this will be remedied at some point), it is very easy to find that number using my "Monthly Payment Calculator: Fixed-rate mortgages" numbered 7a on my Mortgage Calculator page: www.mtgprofessor.com/

Because HOA is an ARM that adjusts monthly, the fully amortizing payment will change a little every month, so borrowers who want to stay on track ought to repeat the exercise periodically.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Contact him at jguttentag@mtgprofessor.com.