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May 21, 2001, Revised
November 30, 2004
Many
lenders offer loan repayment programs that differ from the standard
monthly payment arrangement. The
inducement is an earlier payoff. These
programs can be confusing, and the claims made for them are often
exaggerated. The questions
below illustrate three alternative payment schemes: bimonthly, biweekly
and simple interest biweekly.
Bimonthly Payment Plans
�I
have a 7% bi-monthly mortgage on which I pay 1/2 of the monthly payment on
the 1st of the month and the other half on the 15th. The lender does not
'hold' the payment until the 30th, they apply it to principal right away.
24 payments are made each year, but the 30-year term is reduced to 23.5
years. What do you think?�
There
isn�t anything wrong with the bimonthly, provided you didn�t give up
anything to get it. Whoever
told you that it would reduce the term of a 30-year loan to 23.5 years was
blowing smoke. On a 7%
30-year loan, it takes 718 bimonthly payments, or 29 years, 11 months, to
pay off. In other words, you
knock just one month off the term.
A
bimonthly mortgage involves no extra payments.
You make 24 payments a year instead of 12 but they add to the same
total. By advancing the
payment by half a month, you save a little interest, which means that a
slightly larger part of succeeding payments is used to reduce principal.
The
effect, however, is small. A
standard $100,000 loan at 7% for 30 years would have a balance at the end
of year one of $98,984.19. The
same loan cast as a bimonthly would have a balance of $98,982.66, or only
$1.53 lower. The difference
grows over the years, but only by enough to knock one month off the term.
Biweekly Payment Plans
�I
have been offered a simple interest biweekly mortgage that is said to be
much more powerful than conventional biweeklies because the payment is
applied to principal right away�I don�t understand the difference.�
A
biweekly mortgage is one on which the borrower every two weeks makes a
payment equal to half the monthly payment on a standard mortgage.
The payment on a biweekly is thus the same as that on a bimonthly.
But since there are 26 biweekly periods in a year compared to 24
bimonthly periods, the biweekly requires the equivalent of one extra
monthly payment every year.
This
results in a significant shortening of the term.
For example, the 7% 30-year loan converted to a biweekly pays off
in 287 months � or 23 years, 11 months.
The reduction in term is due entirely to the extra payment every
year.
On
a standard biweekly, the biweekly payments are credited to an account
managed by the lender. The
lender makes the monthly payment out of the account on the first of the
month, just as the borrower would do on a standard mortgage.
The interest earnings on the account belong to the lender.
When a year has elapsed, the excess amount accumulated in the
account is equal to a full payment. It
is only at this point that the lender makes a double payment that depletes
the account.
The
simple interest biweekly differs from a standard biweekly in that the
biweekly payment is applied to principal every 2 weeks, rather than held
in an account. This results
in a faster payoff for the same reason that a bimonthly pays off faster
than a standard mortgage. Again,
however, the difference is small. Where
a 7% 30-year standard biweekly pays off in 287 months, the simple interest
version pays off in 284 months.
Borrowers
who like the idea of accelerating the payoff need not pay extra for the
privilege; they can do it themselves.
By making a double-payment once a year, they will pay off just as
if they had a standard biweekly. Alternatively,
by increasing their monthly payment by 1/12, they will pay off as if they
had a simple interest biweekly. The
only borrowers who should opt for an alternative payment plan administered
by the lender are those without the discipline to stick to a plan of their
own.
Copyright
Jack Guttentag 2004
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