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October 21, 2002, Revised January
13, 2003
"How much more valuable is a
simple-interest biweekly mortgage than a standard biweekly?"
Not much.
On a standard biweekly (SBW), borrowers pay
half the monthly payment every two weeks. Over the course of a year, they make
26 half payments, which is the equivalent of 13 full payments. That extra
monthly payment, however, isn�t credited to the borrower�s account until the
12th month. The account is credited with monthly payments for the first 11
months, and with a double payment in the 12th month. The process repeats in each
subsequent year.
On a simple-interest biweekly (SIBW), in
contrast, each half-payment is credited to the borrower�s account immediately.
In contrast to a SBW, which only credits payments once a month, an SIBW credits
payments every two weeks. This accelerates the reduction in the loan balance,
which results in an earlier payoff and reduced total interest outlays.
As an example, lets look at a 30-year
fixed-rate mortgage of $100,000 at 6%. Without modification, this mortgage
would, of course, pay off in 360 months, and total interest payments would be
$115,832. Converted into an SBW, it would pay off in 295 months and have total
interest payments of $91,927. If instead it is converted into an SIBW, it would
pay off in 294.5 months and total interest payments would be $91,022.
The difference of $905 in interest payments
between the two biweeklies is very small when one considers that it covers 30
years. One way to put it in perspective is to ask, what interest rate on the
SIBW would provide the same interest payments and month of payoff as the SBW?
The answer is 6.063%. A borrower should be indifferent between a 6% SBW and a
6.063% SIBW.
The advantage of a SIBW is reduced even more
if, instead of being compared to a SBW, it is compared to a "13/12
roll-your-own" extra payment scheme. In this scheme, which is completely
under the borrower�s control, the borrower adds 1/12 of the monthly payment to
the payment every month.
A 13/12 would pay off in 295 months, with
interest payments of $91, 279. Interest payments are a little smaller than on
the SBW because the 1/12 extra payment is credited every month.
Interest payments are a little higher on the
13/12 than on the SIBW because of the difference between crediting payments
monthly and crediting them every two weeks. The difference, however, is
altogether trivial. Let�s ask the same question we asked before --how much
higher could the interest rate go on the SIBW before it lost its advantage over
the 13/12? The answer is 6.018%.
The calculations above assume all payments
are made on the due date. But in practice many borrowers pay late.
On a standard monthly payment mortgage, payments can be made up to the 10th or
the 15th day of the month without any cost. A SIBW, in contrast, accrues
interest daily, which means that the borrower pays interest for every day that
the payment is late.
There are some lenders who try to convince
borrowers that it is worth paying an interest rate 2% to 3% higher, and
sometimes more, to get a SIBW. A borrower who was subjected to a pitch
from one of them, reported it to me as follows:
"The way a traditional mortgage works,
every time you pay off any extra principal, nothing is recalculated � extra
payments are only chipped off the tail end of the loan�The way our approach
works, every time you make a payment, the entire loan is reamortized� So
with each and every payment, you�re paying interest on less principal�The
reason we charge a higher interest rate is because we�re putting so much
money back in your pocket."
The description of how "a traditional
mortgage works" is flat-out wrong. I once heard about a small credit union
that held a borrower�s extra payments until they were large enough to pay off
the balance, but this is extremely rare. The overwhelmingly dominant practice is
to credit extra payments on a monthly basis, as I assume in my calculations.
The upshot is that the difference between "reamortizing" biweekly as on a SIBW, and monthly
as on a 13/12, is trivial, and for most borrowers would be offset by the added
costs of daily interest accruals. Don�t let anyone talk you into paying anything for
a SIBW.
Note: All the numbers referred to above were
derived from the biweekly spreadsheets that are available on my web site.
Copyright Jack Guttentag 2003
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