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.