It is extremely important to understand how your mortgage payment is determined before you decide on a bi-weekly payment.
Maroney on Money
Interest rates are once again approaching record lows and you've found the home of your dreams. You've met with your lender and your mortgage application has been approved. All that's left to do now is sit down and sign your name on all those forms that few profess to understand.
Many people, in the euphoria of the moment, simply sign away with little or no thought given to the true financial impact of the agreements they enter.
Bea Smart recently borrowed $150,000 by way of a standard five-year mortgage at 7.2% with monthly payments of $1,079 and a twenty-five year amortization. Could Bea have done better if she had put a little forethought into her decision? Consider the following simple and inexpensive amendments:
Pay more often
A switch from monthly payments to bi-weekly payments would have saved Bea more than $37,000 over the life of the mortgage. In switching to bi-weekly payments it is extremely important to understand how your mortgage payment is determined.
The most advantageous method of calculating a bi-weekly payment is to divide the monthly payment by 2. This method results in an extra mortgage payment per year creating the significant interest saving noted above.
Under this alternative, Bea’s bi-weekly payment would be $540. By applying this new payment she would have paid a total of $14,040 toward her mortgage during the year rather than $12,948 under the monthly method. Although the increase amounts to approximately $91 per month (or $3 per day), Bea would be burning her mortgage in 20 years instead of 25 years.
Some lenders will calculate the bi-weekly mortgage payment by multiplying the monthly payment by 12 and dividing this amount by 26. In this case, Bea's bi-weekly payment would be $ 498, however, at the end of the day when her mortgage is paid-out the interest saving would be a measly $364 and not $37,000. The reason the interest saving is so small is that this method does not provide for an additional mortgage payment each year. The interest saving is created solely by prepayment and not an increase in the amount paid.
If you are paid every two weeks, simplicity suggests that it's best to have your bi-weekly mortgage payments withdrawn from your account on the same day you are paid. Money you don't see is money you won't spend.
Shorten your amortization
If Bea had been prepared to increase her monthly mortgage payment by $102 she could have knocked five years off her mortgage and saved over $ 40,000 in interest. If Bea cannot afford an additional $ 3.29 per day (about half the cost of a pack of cigarettes) she should question whether she can really afford to borrow the funds in the first place.
Clearly, from the borrower's perspective, it rarely makes sense to settle for a 25-year amortization since the first five years of payments represent almost entirely interest. Whenever possible, bump your mortgage payment by whatever small amount is necessary to shorten your amortization period to 20 years rather than sticking with the default 25-year amortization – the interest saving is so large you won’t regret it.
Better yet, why not combine bi-weekly mortgage payments with a shortened amortization? This combination, although very powerful, does require more cash and, therefore, may not be a viable alternative for some people. In Bea's case, her bi-weekly mortgage payment would be $590 (an extra $ 2,392 per year or $ 199 per month) but she would save over $ 62,000 in interest over the life of her mortgage – now that’s not pocket change!
So be smart and spend a bit of time with your lender reviewing various scenarios - you won't regret it.
Jim Maroney is a chartered accountant with Andrews Brown Maroney, Chartered Accountants in Maple Ridge.
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