Accelerated Mortgage Payment Programs
by Donald A. Sanders
Do you want to pay off your mortgage sooner, and save thousands of dollars in interest? This is what we are constantly being asked these days either through the mail, and now on the internet. The common mechanism for doing this is what is called a "Bi-Weekly Mortgage Payment Plan." This article will take a look at these plans, and show you why you may want to consider doing something different. How They Work: Bi-Weekly programs exist when a special account is set up to collect periodic payments. These accounts are either handled by the lender servicing the loan or by an outside agency. There is usually a "setup" fee and a "per transaction" fee payable by the borrower. One-half of the usual monthly payment is collected from the borrower every two weeks through an automatic withdrawal from the borrower's checking account.. Each payment is placed into an escrow account when collected. A check is written against this account each month in the amount of the normal monthly payment and forwarded to the lender on its due date. At the end of twelve months, an extra month's payment has accrued in the escrow account. Therefore, each year an extra month's payment is made to the lender which is applied directly to principal. There are variations to this, such as 1/2 month's payment is paid every six months in addition to the normal payment. (An interesting question: "Is interest being earned on these funds, either direct or indirect, while sitting in this escrow account and, if so, who is getting the interest, or benefit?") The Benefits: This program is for borrowers wanting to pay off their mortgage sooner than they would by making their normal monthly payments. The additional cost is minimal as compared to the long-term benefit of faster debt reduction and thousands of dollars in interest savings. As this is a structured program (automatic checking account withdrawals) it is an ideal way for the undisciplined person to take advantage of accelerated payments. The Detriments: There are usually additional costs involved with setting up the program and handling payment transfers. It may take a period of years for the benefit of reduced principal and interest savings to offset these costs.
If there are insufficient funds in the borrower's checking account at the time of the automatic withdrawal, this could result in an overdraft situation. The extra principal is usually applied toward the loan balance only once per year. Did you ever try to stop an automatic withdrawal of funds from your checking account? The Alternative: If the borrower has the self-discipline, then it might make more sense for them to simply add an additional principal amount with each payment. This method allows the borrower to vary the amount each month depending on their budget and financial needs. The borrower can stop paying the additional amount at any time, and start again when desired. This method applies the additional amount to principal immediately with each payment, instead of once per year, or maybe twice per year. Analysis: For the purpose of this analysis the following will apply:
• • • • • • • • • • •
Loan Amount = $100,000 Interest Rate = 8.000% Term = 30 Years Regular Monthly Payment = $733.76 Setup Fee for Bi-Weekly Program = $395 Transaction Fee Per Payment = $2.50 Equivalent Monthly Payment on a Bi-Weekly Program = $794.91 Transaction Fee Per Month = $5.42 Total Monthly Outlay for Bi-Weekly Program = $800.33 This is an increase of $66.57 per month Extra Bi-Weekly principal is paid once per year
In this case the advertisement would say something like this: "Save up to $43,855 in interest and pay off your loan 7 years sooner." Chart comparing equity build-up using three methods of payment: Normal Bi-Weekly Amortization Accelerate Yourself
Original Loan $100,000.00 $100,000.00 $100,000.00 Year 1 99,164.70 99,164.70 98,335.91
Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15 Year 16 Year 17 Year 18 Year 19 Year 20 Year 21 Year 22 Year 23
98,260.07 97,280.35 96,219.32 95,070.21 93,825.71 92,477.94 91,018.30 89,437.51 87,725.51 85,871.44 83,863.49 81,688.87 79,333.74 76,783.16 74,020.84 71,029.26 67,789.40 64,280.64 60,480.64 56,365.24 51,908.27 47,081.39
97,470.67 95,636.02 93,649.09 91,497.28 89,166.85 86,643.00 83,909.67 80,949.47 77,743.56 74,271.56 70,511.40 66,439.16 62,028.93 57,252.64 52,079.93 46,477.88 40,410.85 33,840.29 26,724.35 19,017.82 10,671.64 1,632.74
96,533.70 94,581.90 92,468.09 90,178.84 87,699.58 85,014.55 82,106.65 78,957.40 75,546.78 71,853.08 67,852.81 63,520.52 58,828.65 53,747.34 48,244.30 42,284.51 35,830.05 28,839.87 21,269.51 13,070.81 4,191.63 -0-
The point of the chart is it shows that if you take the exact same cost for doing the BiWeekly program ($66.57) and added that amount to your regular monthly payment, you get more direct benefit for your money. It may not seem like a significant amount in the beginning, but it tends to have its impact as the years go on. Some people get confused with what the numbers say.A faster payoff may look impressive, but we have to remember that the extra principal we are paying is our money to begin with. Instead of spending it elsewhere, placing it in a passbook savings account, or investing it somewhere, we are choosing to prepay this amount toward a loan to avoid having to pay interest on this amount of money in the future. It also means that a greater
portion of our regular monthly payment will go toward principle reduction as compared to the original amortization (this is the real benefit, as that payment amount is fixed). Chart comparing interest saved: Normal Bi-Weekly Amortization Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 $7,969.82 7,900.49 7,825.40 7,744.09 7,656.01 7,560.62 7,457.35 $7,969.82 7,844.85 7,704.23 7,551.66 7,387.07 7,208.45 7,015.03 Interest Cost Of Interest Saved Saved Bi-Weekly Doing It Yourself Bi-Weekly 55.64 176.81 369.24 638.18 990.35 1,432.67 $460.00 525.00 590.00 655.00 720.00 785.00 850.00 29.95 128.69 301.93 555.87 897.17 1,333.09 1,871.51
As you can see from the above, the savings in interest from the Bi-Weekly program doesn't begin to offset the administrative costs until some point in the sixth year. (The interest saved and the costs shown are cumulative.) So, where is the claimed $43,855 in savings? This doesn't occur unless you pay the loan to full term. If the loan is paid to full term, did you actually save $43,855? No, because the administration costs were $1,895. So, our net savings is $41,960 If you add the additional principal ($66.57) to each month's payment yourself, not only do you pay off the loan faster, but you save $48,592 in interest if you pay the loan to full term. That's a savings of $6,632 over the Bi-Weekly program. Considerations: A person needs to consider how long they expect to be living in their home before signing up for a Bi-Weekly program. Will there be enough direct benefit over that time period to make this worthwhile? I did not carry this chart beyond 7 years because it is unusual for a family to live in the same home for longer than this. You need to understand that the data contained in these charts is for illustration purposes only. Each loan is different. Increasing the interest rate from 8% to 10% makes a significant difference in the outcome. Each loan needs to be analyzed for a benefit comparison. Another factor I have seen is that numerous software developers, and loan officers, do not know how to calculate Bi-Weekly programs properly. How will you know if the analysis
you are given is correct? You probably won't, unless you have a background in finance, have a financial calculator and are willing to do the calculations yourself. And what about the claims that lenders don't calculate your loan balance correctly? This is very rare with fixed rate loans. There is a definite problem when it comes to adjustable rate loans. Bi-Weekly programs apply to fixed rate loans. This is not "rocket science," all we are doing is paying some extra principal periodically, and they usually get that right. Fixed Rate vs. Adjustable Rate Loans: Bi-weekly programs are only applicable to Fixed Rate Loans. Any form of accelerated payments have minimal impact on Adjustable Rate Loans. Here is why: Each adjustment is made based on the current loan balance, the new interest rate, and the remaining term based on the number of payments made -- not the remaining balance. If a borrower made an additional $100 principal payment on a $100,000 fixed rate loan at 10% interest for a year, the remaining balance would be $98,187.58 at year-end. The new remaining term is 325 months instead of 348 months based on a fixed rate amortization. However, when the adjustable rate loan adjusts, the remaining term on a 1-year adjustment is 348 months. Assuming the interest rate does not change, the new payment for the coming year is $866.48 instead of $877.57 when the loan started. This includes the benefit of having made the additional $100 per month principal payment. The only immediate benefit is a slightly lower payment with little interest savings. However, there is no additional reduction in the remaining term of the loan. Conclusion: The next time you are confronted with the "opportunity" to save thousands of dollars on your mortgage, you need to really stop and think about it. You need to ask yourself, "Will a Bi-Weekly program provide me with REAL benefits in accordance with my plans to own this property?"
The content of this article is copyrighted by CommCepts International. You may not use or reprint any portion of this article without the expressed written permission of CommCepts International.