“Mortgage Tip Of The Week: Accelerated Bi-Weekly Payments”
Grrr…. I regularly come across this sort of thing, in finance blogs, financial articles in national newspapers, financial magazines, etc. They all strongly recommend accelerated bi-weekly mortgage payments as a great way to save thousands of dollars of interest over the life of your mortgage. And it wouldn’t bother me at all, if it weren’t for the fact that accelerated bi-weekly payment plans are often touted as ‘near-magic’ ways to save on your mortgage. About ten years ago, while I was working on a mortgage website I’d been hired to develop, the otherwise-very-intelligent woman who was managing the project was completely convinced, by the probably-otherwise-very-intelligent mortgage advisor at her bank, that accelerated bi-weekly payment plans were like magic – easy access to ‘free’ money.
What ARE accelerated bi-weekly payments?
Accelerated bi-weekly payments are where you take the amount that you were planning to pay monthly (say $1000), and divide it by two, then pay that much every two weeks. Like magic (so they say), you’ll pay off your house years earlier, and save thousands of dollars on interest.
In case you’re not familiar with them, here’s a basic example:
As you can see by looking at the first four rows (monthly, semi-monthly, bi-weekly, and weekly payments), if you keep your total annual payments the same ($12000/year), then paying smaller amounts more frequently will have very little effect on how quickly you pay off your mortgage – by paying weekly, the bank gets some of your money sooner, and they reward you with a small decrease in the amount of interest you have to pay. How small? In the example above, you’ll save $2962 over the life of your mortgage, or just under $10 per month. You’ll save as much by skipping a few Starbucks coffees each month.
This is where the apparent ‘magic’ of accelerated payments comes in. If you take your monthly payment, divide it by two, and give the bank that much every two weeks, you’ll suddenly save over $30,000 dollars! Wow! Amazing! Who said there’s no such thing as free money?
The thing is, what you’re actually doing is going from making twelve payments of $1000 to making twenty six payments of $500 (so you’re actually paying an extra $1000 each year). Ten months of the year, you’ll make two payments, each half the size your monthly payment would have been, so everything’s good. But the other two months of the year you have to make THREE payments. Raising the question –
Where are you going to come up with an extra $500 dollars?
So – what SHOULD you do instead?
Now I’m going to give you some advice – and, rather strangely, it’s something I’ve very seldom seen mentioned in any of the articles I’ve read on this topic. Despite the fact that it’s very simple to understand, and a very good way to pay off your mortgage as quickly as possible, without running into problems.
The advice? Choose the frequency of your mortgage payments based on the frequency of your paycheques. If you get paid weekly, then make your mortgage payments weekly. If you get paid monthly, then make your mortgage payments monthly. Ideally, arrange for the payment date for your mortgage to be a few days after your paycheque is deposited in your bank account (that way you’ll be pretty much guaranteed that you’ll have money to make your mortgage payments).
So – if the sound of saving all that money by making accelerated bi-weekly payments is pretty appealing, but you get paid monthly, then arrange to increase your monthly payment amount by 8.3% – you’ll get exactly the same benefit, and won’t have to scramble to find the money twice a year. Conversely, if you actually do get paid every 2 weeks – definitely arrange to pay your mortgage bi-weekly. The very real danger inherent in bi-weekly paychecks and monthly expenses is that, two months of every year, you’ll get that extra paycheque, and it will feel like ‘free money’. Your other two paycheques that month were enough to cover all of your expenses, so the temptation to blow the extra paychque on something fun, frivolous, outrageous… can be pretty hard to resist. If your mortgage payments are bi-weekly, then you’ll be putting some of your money to work for you – and still have some left over to blow on a weekend trip to Vegas (or whatever).
The truth is, there’s nothing magical about accelerated payments. In fact, if you increase your mortgage payments, you will pay off your mortgage faster, and as a result you will save thousands of dollars in interest. That’s all there is to it.
Note: these numbers were for a $150000 mortgage, amortized over 25 years, at an interest rate of 6.45%. I chose them because they gave nice round numbers. We could change it to $350000, and an interest rate of 3.25%, to make it more realistic, but the message stays the same – there’s nothing magic about ‘accelerated’ mortgages – you’re just agreeing to increase your payment size so that you can pay off your mortgage more quickly. Which is a great thing to do. But it doesn’t require that you choose a payment frequency that isn’t a good fit for you.