Q:

Should I pay the interest or the principal on my second mortgage?

We have a second mortgage on our home from 10/08.  It was designed to be deferred for five years, so we're right in the middle.  After the deferral, our monthly payment will be $413.74 for 25 years.  The original balance was $51,000.  The interest rate is locked at 5.75%.
We didn't want to just let the interest accrue for 5 years, so we asked our broker what the monthly would be on this loan if it was not deferred and if it was stretched over 30 years.  He came back to us with a $297.62 monthly payment, and we've been paying that ever since.  Our balance is now down to $49,133, since most of that payment goes to paying the accrued interest.
Last week, I was on the phone with the bank, and the agent showed me how instead of doing a bill pay to that mortgage like I was doing, I could put it through as a Transfer and designate that it all goes to principal.  I did it as a test, checked today, and sure enough, it was all applied to the principal.  
The loan docs state that any payments will always first cover the interest first, and then the principal, but I guess since it's technically deferred, we're in this gray zone, where we can actually attack the principal without first paying the interest.
So....
We've now decided we have $500 a month to put towards this loan.  What will save us the most money?  Putting the $500 towards the principal, or paying off the accrued interest (around $230) and putting the rest towards the principal?  Keep in mind that we only have about 2.5 years left of being in this gray zone, before our monthly payment will have to first be applied to the interest.
Thanks!

A:

The fundamental question I'd have to ask here is - when will the interest you owe on the loan on your house be capitalized? 
I think thats a fancy way of saying - how is your bank calculating the amount of interest on the loan? Is it based purely on the principal, or on the principal + existing interest? 
Your situation is similar to that of having a student loan - it sounds like your loan is in deferment, but is equivalent to being "unsubsidized" - that is, you still are being charged interest on the loan. The question really boils down to - will you be paying interest on only the principal of the loan or both the principal and the interest of the loan? 
Here are some helpful steps:

Become familiar with capitalization. Here's a helpful webpage for learning about capitalization 
(optional) For your own learning, understand how capitalization of student loans works
Ask your bank when the interest on your loan is capitalized. If the interest on the principal is capitalized immediately, I believe that means we're dealing with a classic compound interest problem. 

If the interest is capitalized immediately, I believe it is correct to say it doesn't matter if you pay the principal or the interest of your loan first. If the interest is NOT capitalized until your deferment period is over, then its definitely best to pay off the principal first. 
Hope this helps.

A:

No offense to any bankers who are reading, but i find it remarkable that they can confuse what I'd expect to be an otherwise simple explanation. If at the end of each day the interest is added, you go to sleep with a new balance. At the moment it's added, you have no interest due, just a higher principal amount than when you went to sleep last night.
When I view my loan, I know how much interest added to principal since the last payment. Any amount I pay over that has to go to principal.
Forgive me, but the rest sounds like nonsense.

