How current events impact business & real estate

Friday, November 23, 2012

Bi-Weekly Mortgage Payment Plan - Its the extra payment that matters!

During this Thanksgiving I was spending time with some good friends who recently purchased a house. They are great people, but not particularly knowledgeable about the real estate industry.

My friend said to me that his wife and him were discussing setting up automatic payments for their mortgage, which I thought was a good idea so they would never miss a payment.

Then, my friend said that once they got situated in their new house that they would switch to paying every other week to cut down their interest and make the mortgage term shorter. My response was simple, "So you are going to make an additional payment a year on your mortgage?". He responded with "No, I am just going to pay every other week and we will save money, everyone does that", as if I was some sort of fool who had no idea how mortgages worked - thanks for the lesson. I thought that I may share with him why he doesn't understand what he is talking about, but on second thought I thought it is Thanksgiving and he didn't ask me for my professional advice, so I should keep my mouth shut.

To be clear, paying every other week as opposed to monthly is not a magic trick. The bank is not happy to merely receive payments in partial amounts more frequently than in full amounts monthly. Instead, paying bi-weekly results in 26 half payments throughout the course of a year. 26 half payments equals 13 full payments. Math not magic is what matters. So, the result is that a bi-weekly payor is making 1 extra payment a year and that is the SOLE reason that a loan's term is accelerated by expeditiously reducing the loan's principal balance. Moreover, as you reduce the principal, the amount of interest paid is reduced. This is actually what my friend was saying; albeit confusedly. In fact, it works the same if you simply make 13 payments a year as opposed to 12.

However, mortgagors (borrowers) should not EVER unilaterally decide to make bi-weekly payments. Instead, they must discuss their desire with their lender first. Many lenders want a one-time setup fee for this service and require online payments as opposed to checks.

Or, instead, mortgagors (borrowers) can simply send an extra payment annually and they are set.

Enjoy the holidays. I've learned that when I keep my mouth shut I enjoy the holidays too.