There is not a month that goes by where I don’t receive a solicitation pushing for me to pay off my mortgage more quickly by participating in a biweekly mortgage payment plan.
You’ve probably heard that accelerating your mortgage payments can substantially reduce the amount of interest you’ll pay over the life of the loan. Even with today’s rock bottom interest rates, extra payments may make sense for you.
Unfortunately, many of the accelerated payment programs can be confusing, and companies may be exaggerating how much you can save over time. Given the number of options out there, it’s important to be clear what the terms are before making the commitment.
The three most common ways of accelerating mortgage payments are paying bimonthly, paying biweekly, and paying extra principal. Let’s look at each one.
Paying bimonthly. In this context, bimonthly means twice a month. With a bimonthly mortgage payment, a payment service takes half the monthly mortgage payment from your bank account twice a month, but payments are only applied to the loan once a month.
Paying biweekly. With a biweekly plan, you’ll pay half your monthly mortgage payment every two weeks. Since there are 26 biweekly periods a year compared with 24 bimonthly periods, biweekly schedules produce the equivalent of one extra monthly mortgage payment each year.
Paying extra principal. Each month you have the option of paying an extra amount over and above your minimum monthly payment. While your minimum payment goes to both principal and interest, any extra amount you pay towards principal further reduces the amount you owe, which reduces the amount of interest charged on all future payments.
What’s the difference to the bottom line? For our baseline, let’s start with a 30-year fixed-rate mortgage with a balance of $200, 000 at 6% APR. In round numbers, if you made 360 minimum monthly payments of $1, 199, you’d pay a total of $431, 676 (principal and interest only, not including taxes and insurance). Now let’s see the effects of each type of accelerated payment program.
Bimonthly payments
In a true bimonthly (or semi-monthly) payment plan, you pay half your monthly payment twice a month. In our example, you’d pay $599.50 on the 1st of the month and another $599.50 on the 15th of the month. You’ll make 24 payments a year as opposed to 12, but your total monthly payment is the same, $1, 199. As a result, your total payments are still $431, 676.
Most true bimonthly programs simply hold your first payment until the end of the month and then send both payments to your lender at the same time. You won’t see much, if any, savings because the lender is still amortizing based on monthly payments. Your only benefit is the ability to split your mortgage payments each month, which might be better for your cash flow situation.
Biweekly payments
Paying biweekly (every two weeks) means you’ll make 26 payments a year instead of 24 (or 12), effectively making one extra mortgage payment a year. Assuming your lender credits the payments as they are received (for which they may charge a fee), the benefits are not only a faster payoff, but also lower interest costs over the life of the loan. If you get a paycheck every two weeks, it might make sense to time your mortgage payments to match.
In our same example, paying $599.50 every two weeks will pay off the 30-year mortgage within 24 years for a total of $382, 094, or a savings of $49, 582.
To experience the largest cost savings, this true or simple interest biweekly payment must be credited immediately upon receipt by the lender as opposed to once a month. Interest also must be calculated for two-week intervals and the biweekly payments less the interest must be applied to the mortgage amount in order to reduce its principal every two weeks.
Extra principal payments
Instead of signing up for an accelerated payment program, what happens if you simply make monthly payments and add something extra each month to pay down the principal? Using our same example, paying an extra $100 per month (one-twelfth the monthly payment) will pay off the 30-year mortgage within 24 years for a total of $382, 538, which is very close to the biweekly option, but without the added cost of paying someone else to set up the program.
Before committing to any new mortgage payment schedule, it’s important to confirm, not only the payment amount and frequency, but also the timing of when the payment will be credited to the account, which will impact the interest payments over the life of the loan. By doing this, you can better determine the overall savings on your mortgage amount.
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If you are paid every two weeks, put aside half the mortgage each paycheck.
You’ll find that twice per year when the mortgage is due, you have three half payments instead of two. That’s when you make the extra principal payment. This will save you about 99% of the amount saved on a true bi-weekly setup.
This is a great painless way to slice time off the loan. But, I think Nickel would agree, it’s 4th. After depositing enough to get the 401(k) match, after paying off all higher interest debt. And after having a decent funded emergency account.
So, would it be smarter to pay an extra lump sum of $1200 once a year, or an extra $100/month? Does it matter in the end?
Nickel: We’re actually paying a little extra each month as our budget and cash flow permit. We’ve also verified that the lender is applying these extra payments to principal.
However, the lender is not adjusting the amortization schedule to reflect the extra reduction in principal. We end up paying the same interest amount as if we just paid the regular payment, which largely negates the advantage of paying extra principal. We’ve reviewed the loan agreement a couple of times to see if this practice violates the agreement, but we can’t locate the language which specifies how interest is calculated — beyond a generic “prepayments may lower your finance charge after the first adjustment date” (this is 5/1 ARM).
If we could refinance to get away from this lender, we would do so in a heartbeat.
jeffbone: Instead of making extra payments, just make a larger payment each month. Details are above, but paying an extra 1/12 each month is almost exactly the same as making biweekly payments in the long run. Just make sure they apply the overpayment to principal.
My lender won’t allow us to pay biweekly. They claim their processing systems can’t handle the payments properly. I suspect this assertion is true, since they also do not reduce the interest due when we pay extra principal.
Yes, we are in the market for a new lender. Unfortunately, we’re basically locked into this one, as we’re currently $30k underwater and ineligible for the government refinance (HARP, etc.) programs.
My Quicken Loans sounds similar to Sarah’s experience with Citimortgage. It is easy to pay extra principal and modify as needed.
I don’t recall either of my previous lenders being this easy on their web interface but it has been a while.
Watch out for the additional costs associated with biweekly payment plans. I got an offer from my mortgage servicer to enroll in such a plan, for a one-time enrollment fee of $375 and then $1.50 transaction fee per payment. No thanks!
I got a Citimortgage offer yesterday to set up biweekly paymentsâ??for a fee of $375. I just pay extra principal each month (via autodeduct) to pay a 30-year in 18 years (though I’d like to do in 15, as BG says). And it cost me nothing to set it up.
Go with a 30-year fixed mortgage, and pay it like a 15-year mortgage (basically the third option presented). If cash-flow is tight one month, you have the luxury of making the smaller 30-year monthly payment. If you don’t hit any bumps, you end up paying the house off in 15-years (saving a ton of interest), but at the cost of having the slightly higher 30-year interest rate on a loan you effectively paid off in 15 years.
I think the slightly higher rate on the 30-year note is worth it for the option to pay the lower (30-year) payment on a tight month. Strive to pay the loan off in 15 years (or less).
We do extra principal payments. Our mortgage payment is directly debited by Citimortgage. We can tune that debit information at pretty much any time. There is a field for “additional principal” and we have it set for for an extra $50 per month. If for any reason we want to change it, our change is effective for our next payment. Citimortgage has applied these correctly as I check them periodically with my own amortization table.
The flexibility is why we chose this method and have been very happy with the outcome… over two years saved off our mortgage already.
The vast bulk of savings from biweekly payment schemes is from the extra 1/12th of a payment spread out over the year. Crediting the payment two weeks earlier is nearly irrelevant. All you save is the interest on the extra $100 for 14 days. That means a whopping 23 cents of interest every month, a total of $67 of the (shorter) life of the loan.
If you have cash flow and/or discipline problems, and get paid biweekly, and determine (despite your cash flow problems and today’s at-or-below-inflation interest rates) that you should prepay your mortgage, then a biweekly plan might be worth it for you. Otherwise, if you have decent cash flow, you can set up your automatic payment to be 1/12th bigger, for the same effect without the hassles or extra costs to set up a biweekly plan.