Using a Troubling Innovation in Real Estate Finance to Teach Loan Amortization Mechanics

This paper describes an innovation in mortgage finance that may reduce the benefits of making extra mortgage payments. Specifically, some loan servicers may not be using such payments to immediately reduce loan principal. Examples are provided to show that, ceteris paribus, this procedure can result in a substantially longer time until debt elimination, more total interest expense, and higher effective interest rates compared to loans where additional payments are traditionally applied. The effects are shown to be sensitive to the loan interest rate, the original loan life, and prepayment size, and to apply to both fixed-rate and adjustable-rate mortgages.