How to Handle Extra Payments When You Have 2 Mortgages

NEW YORK ( TheStreet) -- It's a good news/bad news situation. The bad news is you've been struggling with payments after taking out a second mortgage some time back. The good news is that you're prospering and ready to make extra payments to trim your debt.

So which loan should you focus on? The original mortgage or the second one?

The answer is simple: The top priority should be reducing the loan with the highest interest rate. Unfortunately, many homeowners get this wrong because of common misconceptions about how mortgages work, says Jack M. Guttentag, emeritus finance professor at The Wharton School.

Many borrowers believe incorrectly that they should pay down the older loan first, because more of each payment goes to principal rather than interest, Guttentag says on his website, TheMortgageProfessor.

The most common type of mortgage is the 15- or 30-year "fully amortizing mortgage," or FAM. The interest rate and monthly payment are fixed for the life of the loan. But each payment is divided, with a portion going to interest charges and a portion to the loan balance or principal. In the early years of the loan, most of the payment is interest, with very little to principal. In later years it's the other way around.

Suppose, for example, you took out a $100,000 mortgage at 4.5%, about today's average. For each of the 360 months, you'd pay $507 for interest and principal. In the first month, that would cover $375 in interest, $132 in principal. In the 359th month it would be $3.78 for interest, $503 for principal.

Guttentag says that many people believe, incorrectly, that this is something of a scam, with the lender getting paid the lion's share of its interest upfront, earlier than it should. According to this reasoning, making extra payments on a relatively young loan just pays interest and doesn't significantly reduce the debt.

But the conspiracy theory is wrong. In fact, each month's interest payment is figured by applying the interest rate to the remaining debt. Interest charges are big in the early years because that's when the debt is largest. As the debt gets smaller, the interest charge gets smaller. That allows more of the total payment to go to principal.

And, in fact, when you make an extra payment, all of the money goes to principal, none to interest. So an extra $100 payment reduces the debt by $100. That saves you the interest charges on that $100, for a savings of $4.50 a year with a 4.5% loan. Escaping this interest payment is like earning 4.5% a year on that $100.

If the loan charged 6%, reducing the principal by 6% would be the same as earning 6% on the $100. So, if you had two loans, one charging 4.5% and the other 6%, you'd get more bang for your buck by paying down the 6% loan first.

Of course, with a fully amortizing mortgage, making extra payments won't reduce the size of your future monthly payments. Instead, it will allow you to pay the debt off early, saving you years of interest charges. Use the prepayment feature on this Mortgage Loan Calculator to see the effect.

The strategy gets a little more complicated if the second mortgage has a variable rate, which is common with a home equity line of credit. With this type of second mortgage, you don't know what interest rate you'll be charged in the future, since the rate is reset every month.

If you had a fixed-rate mortgage plus a HELOC with a lower but variable rate, you'd have to make your best guess about what the HELOC would charge in the future. If you thought the HELOC would soon have a higher rate than the fixed loan, it would makes sense to direct your extra payments to the HELOC. But if you thought that risk was some years off, it would pay to direct the extra payments to the fixed loan, since it would charge more for the foreseeable future.