(This is Part 2 of a two-part series. Read Part 1, “Mortgage-interest tax break lacking in benefits.”)
When the last week of August quickly slipped into Labor Day weekend, the Cashen kids decided the time had come to take over the loan payments of the family cabin from their parents.
Each of the three kids and their families had enjoyed their allotted time at the lakeside retreat fishing, water skiing, sailing and visiting with longtime lake families who, like them, had children of their own.
The financial shift had been in the works for some time, yet was brought to a head when the folks refinanced the place on a 30-year, fixed-rate loan (“I’m not gambling on those ARMs,” said Grandpa Gene) and had taken the $300,000 in funds to buy a condo in Tucson, Ariz.
It was not the first time the lake place had been refinanced. Gene pulled out cash for two college tuitions and years ago plunked down $7,000 to secure a spot for his mom at a popular nursing home. The lake home has been more than a coveted gathering spot — it’s been a consistently appreciating asset.
The Cashen situation was truly amazing — all of the three grown children wanted to keep the lake home and planned to use it; all of them got along and their kids were best-friend cousins; and all of them, bolstered by their spouses, earned a family income that could handle their share of the cabin payment.
Irene, the oldest, suggested a biweekly payment option. She got the idea from a solicitation that arrived in the mail. It suggested the family could save thousands in interest dollars by paying off the mortgage sooner via two payments a month rather than the single monthly payment. A total of 26 biweekly payments would be made instead of the usual 12 monthly payments, amounting to an “extra” month’s payment every year. This conversion could be done for “free,” according to the offer.
Solicitations for biweekly payment plans have become common as borrowers look to counter the recent “foreclosure” buzz by taking a shot at paying off their homes faster. Instead of the standard one-payment-per-month schedule, some companies specializing in accelerated payoff programs solicit mortgage brokers with a custom option for their loan customers. For a one-time fee of $395, the borrower can have a tailor-made plan written for their loan. The mortgage broker is offered an incentive, typically $300, to “sell” the program to his customers.
The sales pitch typically focuses on the ability to accrue equity faster, saving thousands of interest dollars, maintaining a better credit rating because electronic transfers are rarely late and a hassle-free prepayment amortization schedule generated by the lender.
Sometimes, the original lender will offer a biweekly program at no cost to the borrower. To qualify, borrowers usually are required to authorize an electronic transfer of half the monthly payment every two weeks. The extra money is then applied to the principal of the loan. Interest savings can differ depending upon when the payment is applied to the principal.
Let’s look at a basic prepayment schedule. Rather than 12 monthly payments of $2,097.65 on a 30-year, $300,000 mortgage at 7.5 percent, a borrower would make 26 biweekly payments of $1,048.93. As a result, total interest would shrink by $114,715 from $455,145.45, and the loan term would shorten to 283 months from 360 months, a savings of six years and five months.
If the biweekly payments were applied precisely at mid-month and not at the end of the month, the borrowers would save even more interest dollars — a total of $120,299.42 and about 80 months of payments rather than 77. This savings can go to the lender (one of the ways the program comes “free” to the borrower) unless clearly stated in the agreement.
The Cashens eventually elected to make extra payments to the 30-year, fixed-rate loan that amortized the loan over 20 years, saving the children $175,118.51 in interest over the term of the loan. The extra monthly payment that reduced the loan term was $319.13, bringing each child’s share to $806 a month ($2,097.65 plus $319.13, divided by 3).
It’s true — anybody can prepay a loan. Any additional money added to the monthly payment almost always goes to the principal automatically. If you are aiming at reducing your loan term, consider a 15-year fixed-rate loan because it usually comes with a 0.35-0.4 of a percentage point discount from the 30-year fixed. While the Cashen’s will save money by prepaying, their interest rate will remain the same.
To get even more valuable advice from Tom, visit his Second Home Center.