Question: We have been approached by a company that offers a bi-weekly mortgage plan. Our question is very simple: how much will we save on average per year?
Answer: This is one of those deals where you get to pick the “truth.”
If you have a $200,000 mortgage at four percent interest, the cost for principal and interest will be $954.83 per month over 30 years. The annual mortgage expense is $11,457.96 (12 x $954.83).
If we go the bi-weekly route we first divide the usual monthly payment in half ($954.83 divided by 2 = $477.415) and we then make 26 payments. Our cost for the year is $12,413 (26 x $477.415).
Truth #1: We save nothing in year one. Loan costs actually increase with a bi-weekly loan from $11,457.96 to $12,412.79.
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Okay, but doesn’t a bi-weekly mortgage cut interest costs?
Yes, it does. In our example, a $200,000 mortgage at four percent will have an interest cost of $143,738.80 over 30 years.
If we make bi-weekly payments, the interest cost over the life of the loan will fall to $121,236.36. We can save as much as $22,502.44.
Truth #2: If we hold each loan until it is fully paid off, the bi-weekly mortgage will allow us to save $22,502.44.
Wait, if a bi-weekly costs more per year, why does it have a lower interest cost?
With a bi-weekly program we are paying more to the lender each year, and therefore the length of the loan gets shorter. Instead of 30 years, the bi-weekly loan will be paid off in 25.88 years. We will cut the loan term by a little more than four years, and that’s where we save money.
Truth #3: We will cut the loan term with a bi-weekly mortgage if we keep the loan to term.
The question is how much interest do we save on AVERAGE each year with a bi-weekly loan.
The bi-weekly loan saves us $22,502.44. The loan is outstanding 25.88 years. The average annual saving – which does NOT exist in reality – is $869.49 ($22,502.44 divided by 25.88).
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Truth #4: As most people understand the idea, there is NO average annual saving because all of the savings are at the end of the loan term. The math to figure out an annual average saving is both accurate and irrelevant.
But – in fact – the actual annual payments are generally higher with a bi-weekly loan than with a 30-year mortgage.
But isn’t saving $22,500 over the loan term a good thing?
Yes, but you won’t save $22,500.
First, the bi-weekly mortgage plan company has to get paid. Let’s say their fee is equal to the first plan payment ($477.415) plus $3.50 per payment for an administrative fee (673 bi-weekly payments x $3.50 = $2,355.50).
In this example, the plan has a cost of $477.41 plus $2,355.50 or $2,832.91. This is money which is not being used to reduce the loan balance.
Second, the typical seller in 2016 “was in the home for 10 years before selling,” according to the National Association of Realtors. This means few mortgages last 30 years or anything close.
Truth #5: Because of administrative costs and the amount of time you are likely to own the property, the odds of getting all potential savings over the entire loan term are small. However, if you sell the property early you will owe less to the lender because of the prepayments which have been made with a bi-weekly program.
Can you create a bi-weekly program without fees?
Virtually all lenders – but not all — allow you to make a payment for “extra principal” each month without a prepayment penalty. Instead of paying $954.83 per month in our example, pay $1,034.42.
That’s $12,413 per year – the same as a bi-weekly program. The loan will be repaid in a little less than 26 years if held to term so a borrower would again save about four years of payments.
The attraction of the voluntary extra principal approach is that no money is spent on fees or charges. It’s voluntary, so if you have a tough month you can just make the required payment. And, again, if you sell before the end of the loan term you will simply owe less to the lender because of the prepayments.
Truth #6: Run the numbers for yourself or with a mortgage loan officer. Then do what’s best for you.
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