Q. We bought our townhouse in February of last year,
and obtained a very favorable mortgage interest rate of 6.25
percent. Recently, we received a letter from our lender,
suggesting that we pay off our loan on a bi-weekly basis. Our
lender tells us that by doing this, we will not only pay off our
loan 9 years earlier, but end up paying considerably less in
interest. What are the advantages and disadvantages of accepting
such an arrangement?
A. I need help here. Can anyone advise me whether
bi-weekly means twice a week or twice a month? This has often
puzzled me, although in your situation, the lender is asking you
to make two payments per month instead of just one.
There is no question but that if you make extra mortgage
payments, in the long run you will pay off your mortgage earlier
and will pay less mortgage interest over the life of the loan.
In order to understand how mortgage loan balances are
calculated, let’s look at this simple example. You have
borrowed $100,000, and obtained a 30 year loan at an interest
rate of 6.25 percent. The amortization table that I use tells me
that to fully pay off (amortize) that loan over the full thirty
years, the monthly mortgage payment has to be $615.72.
For those of us who still use calculators to add and
subtract, this is how the first three payments are applied to
your loan: $100,000 x 6.25% equals $6250. Divide this number by
12 and you get $520.83, and this is the amount of interest which
will accrue in the first month after you borrow $100,000.
Your monthly payment, however, is $615.72. The difference
between that number and the interest is $94.89 (615.72 - 520.83
= $94.89), and this amount is credited toward the principal
balance of your loan. Thus, at the end of the first month, your
then outstanding balance has been reduced to $99,905.11
($100,000 - 94.89 = $99,905.11).
The process continues:
-- payment two. The interest on the outstanding balance now
becomes $520.34 (99,905.11 x 6.25% = 6,244.07 divided by 12 =
$520.34). Again, your payment of $615.72 will leave a balance of
$95.38, which will reduce the outstanding balance down to
$99,809.73,
– payment three. The interest on the outstanding balance is
now $519.84 (99,809.73 x 6.25% = 6,238.10 divided by 12 =
519.84. The difference between this amount and your monthly
mortgage payment is now $95.88, and will give you a new
outstanding balance owing to your lender in the amount of
$99,713.85 (99,809.73 - 95.88 = $99,713.85).
As can be seen, mortgage interest payments go down painfully
slow for the first seven years of your loan.
Now, let’s assume that instead of making one monthly
payment in the amount of $615.72, you make two payments each
month in the amount of $307.86 (one payment on the first of the
month and the second on the 15th).
When the first bi-weekly payment is due, the initial interest
on the $100,000 you borrowed will be $260.42 (in other words
half of the first monthly interest charge). Your first payment
will leave a surplus of 47.44 (307.86 - 260.42 = 47.44), thereby
reducing the outstanding principal balance down to $99,952.56
(100,000 - 47.44 = 99,952.56).
The second half of the first month will now generate interest
in the amount of $260.29. Now, the bi-weekly payment of $307.86
will be $47.57 more than the interest needed, thereby reducing
(at the end of the first month) the outstanding principal
balance down to $99,904.99.
If you compare the outstanding balance at the end of the
first month for each plan, you can see the difference:
– payment once a month leaves a balance of $99,905.11;
– payment twice a month leave a balance of $99,904.99.
You may scoff at the fact that the difference is only 12
cents, but cumulative over the life of the loan, there will be a
significant savings.
Now let’s analyze the pros and cons of such a program.
Clearly, from the positive side, there is no question but
that paying your mortgage twice a month will reduce your
mortgage interest over the life of the loan. Keep in mind that
if you make your payment once a month, every year you are making
twelve mortgage payments. However, when you pay bi-weekly, you
are also making one additional payment every year (52 -2 = 26
divided by 2 = 13).
From the negative point, however, you have to first find out
what fees the lender will require you to pay in order to set up
this bi-weekly program. From my experience, most lenders will
impose a charge in order to allow you to change your payment
system. And this charge may just not be worth the effort.
Additionally, most lenders who offer the bi-weekly require
that the borrower make automatic payments directly from their
bank. Many people would prefer to write their own checks, rather
than have this automatic system in effect.
Finally, if you can discipline yourself, you can accomplish
the same result without the formalities involved in making the
change. Each and every month, you can pay an additional sum of
money, over and above the amount required by your lender. In our
example, your monthly mortgage payment is $615.72. If you
decided to round up this payment every month, and send your
lender a check in the amount of $700, the additional $84.28 will
be credited toward principal, and will dramatically reduce the
length of your loan and the amount of interest you will have to
pay.
The general rule of thumb is that if you make one additional
mortgage payment each year, you will reduce a 30 year mortgage
down to about 22 years. However, keep in mind that if you make
these additional payments, you must advise your lender – both
on your check and on their billing statement – that the
additional amount is to be applied to the principal balance on
your loan. Otherwise, some lenders will just keep those funds in
a suspense account, and it will not be credited to your
mortgage.
Additionally, at the end of each year, you should carefully
analyze your loan balance, to make absolutely sure that your
additional payments have been properly credited.
Paying a mortgage on a bi-weekly basis does make sense, but
it is not the only way to reduce your mortgage balance. You have
to review your legal documents – promissory note and deed of
trust – to make sure that there is no pre-payment penalty
associated with your loan. If there is no such penalty, you have
the absolute right to make additional monthly payments, without
having to be legally required to make a payment every two weeks.
Do the numbers and you will probably save yourself a lot of
money in the long run.
Published: April 1, 2002
