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.
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.
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.