A borrower makes the scheduled payment plus an extra $300 designated for principal on a fixed-rate mortgage with no prepayment penalty. What is the usual effect?
Correct Answer
C) The extra amount lowers principal and can reduce future interest and shorten payoff time
Why this is correct: An extra payment applied directly to principal reduces the loan's outstanding balance immediately. Future interest is calculated on this new, lower balance. If the borrower continues making the regular scheduled payments (which are calculated to pay off the original balance over the original term), more of each future payment goes toward principal because the interest portion is smaller. This accelerates payoff and reduces the total interest paid over the life of the loan. Why the other choices are wrong: The choice "The note rate increases" is incorrect; making a principal prepayment does not alter the contract interest rate. The choice "The original principal balance increases" is incorrect; the original balance is the amount borrowed at closing; extra payments reduce the current balance, not increase the original. The choice "The extra amount must be added to escrow" is incorrect; funds designated for principal reduction should be applied to principal, not to the escrow account for taxes and insurance. Exam tip: For loans without prepayment penalties, principal prepayments are a powerful tool for saving interest. Always instruct borrowers to clearly designate such payments "for principal reduction."
Why This Is the Correct Answer
Why this is correct: An extra payment applied directly to principal reduces the loan's outstanding balance immediately. Future interest is calculated on this new, lower balance. If the borrower continues making the regular scheduled payments (which are calculated to pay off the original balance over the original term), more of each future payment goes toward principal because the interest portion is smaller. This accelerates payoff and reduces the total interest paid over the life of the loan. Why the other choices are wrong: The choice "The note rate increases" is incorrect; making a principal prepayment does not alter the contract interest rate. The choice "The original principal balance increases" is incorrect; the original balance is the amount borrowed at closing; extra payments reduce the current balance, not increase the original. The choice "The extra amount must be added to escrow" is incorrect; funds designated for principal reduction should be applied to principal, not to the escrow account for taxes and insurance. Exam tip: For loans without prepayment penalties, principal prepayments are a powerful tool for saving interest. Always instruct borrowers to clearly designate such payments "for principal reduction."
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