“My husband and I get paid biweekly. This year I made sure the mortgage payment was made every other paycheck. Next pay day (Oct. 26) I will be making the December 2007 payment. I figure I will be making one extra payment per year at this pace. My husband wonders whether or not this will really work to our advantage?”
The answer is “no.” While it is convenient for you to make a monthly payment every four weeks, you won’t benefit if your lender does not have a program that accepts payments on a four-week schedule. I have never seen a four-week payment plan.
When you make the payment due Dec. 1 on October 26, the lender will credit your payment as of Dec. 1, when it is due, not on Oct. 26. You will not shorten the life of your mortgage doing this, and you will give up the interest earnings on your advance payments. The interest on the money from Oct. 26 to Dec. 1 will be earned by the lender rather than by you.
Many lenders have biweekly payment plans under which borrowers make half the monthly payment every two weeks. They are especially convenient for people like you who are paid biweekly. If you pay half the monthly payment every two weeks, over the course of a year you make 26 half-payments, which is the equivalent of 13 full payments.
Most biweekly programs credit payments monthly, while a few credit payments biweekly, which is worth a little more to the borrower. Crediting payments every two weeks means that the balance is reduced every two weeks, which saves a little interest within each month. You can see exactly how much interest you will save, and the difference in pay-off period, by entering the same mortgage in calculators 2b and 2bi on my Web site, and comparing the results.
As an illustration, a 30-year, 6 percent mortgage will pay off in 297 months if the biweekly payments are credited monthly and in 294.5 months if payments are credited biweekly.
So your task number one is to see if your lender has a biweekly payment program, if so, whether payments are credited monthly or biweekly, and what it costs to participate. Costs are relevant, because you have the option of setting up your own program. Your decision should depend on whether the convenience of using the lender program rather than your own is worth whatever the lender is charging for it.
There are two ways to set up your own system that are independent of and do not require the permission of the lender. One involves setting up a special bank account into which you deposit biweekly payments, and out of which you make your monthly mortgage payment. Every 12 months, there will be enough in the account to make a double payment. This would exactly mimic a lender biweekly program with payments applied monthly.
A second method of rolling your own extra payments program will closely approximate the results from a lender program on which payments are credited biweekly. This is to increase the size of your monthly payment by 1/12 of the payment. If your payment on a $100,000 loan at 6 percent is $599.56, add 599.56/12, or $49.96, to it, making your payment $649.52.
Borrowers paid biweekly can manage such a program with the same type of bank account that I proposed earlier for administering a biweekly program. The difference is that you would need to deposit an amount equal to a payment at the beginning. Borrowers paid monthly don’t need such an account; they can simply allocate a larger amount every month.
Making a monthly payment that includes an extra 1/12 of the payment is almost as effective as a lender biweekly program with payments credited biweekly. The payoff period in the example given earlier is 295 months, compared with 294.5 months for the lender program.
Not many lenders offer biweekly programs that credit payments biweekly. One that does is Primerica, which charges a premium price for it — in the deals that I have seen, the Primerica interest rate is about 2 percent higher than the rate on a comparable mortgage that does not have the biweekly payment option.
Primerica justifies the rate difference by pointing to the lower total interest charges over the life of their loan relative to a standard loan with a lower rate. This is an invalid comparison because the Primerica loan includes 13 monthly payments a year and the standard loan only 12. Compared with a standard biweekly that also has 13 payments a year or with the simple approach of increasing the payment by 1/12 every month, the Primerica loan with the higher rate is a big loser.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.