Dan Marchiando's Mortgage News Blog

Money, not Magic, Pays Off Mortgage Faster

February 5th, 2009 5:27 PM by Dan Marchiando

 

Many lenders and middleman companies offer loan repayment programs that differ from the Standard Monthly payment that most people have when they obtain a conventional first mortgage. The promise made is an earlier payoff, which in turn saves interest. Differences between these programs are confusing, and the claims made for them are often exaggerated. The examples below illustrate some alternative payment programs, plus a couple Do-it-Yourself options. Your payoff results will vary slightly from the examples given, due to differences in loan amount and interest rate.

1. Semi-monthly Payment

With this option, the Standard Monthly payment is divided in half and applied to principal on the 1st and 15th of each month, resulting in semi-monthly compounding of interest (as opposed to the monthly compounding of interest in the Standard Monthly payment).

Unfortunately, a Semi-monthly payment does little to reduce the life of a loan. On a $350,000 6½% 30-year loan converted to Semi-monthly, it takes 29 years, and 11 months to pay off. In other words, you knock just one month off the term, so it wouldn't make sense to pay someone to set up this kind of plan.

A Semi-monthly mortgage involves paying no extra money each year than you would with a Standard Monthly mortgage. You make 24 payments a year instead of 12, but they add up to the same annual total. By advancing the payment by half a month, you save very little interest—$5.42 in the first year using the example above. The difference grows over the years, but only by enough to knock one month off the term. This loan type is very rare, probably because the savings are so minimal.

2. Standard Biweekly

On a Standard Biweekly, a payment equal to half the Standard Monthly payment is paid every two weeks, or 26 times per year. The payment amount on this Standard Biweekly is thus the same as that on the Semi-monthly in #1. But since there are 26 biweekly periods in a year compared to 24 semi-monthly periods, the biweekly requires the equivalent of one extra monthly payment every year. In other words, the borrower pays more money per year than they would with a Standard Monthly mortgage, and more money than they would with the Semi-monthly in #1.The Standard Biweekly payments are credited to a bank account managed by the lender or middleman. The lender or middleman makes the Standard Monthly payment out of their bank account on the first of the month, just as the borrower would do on a Standard Monthly mortgage. The interest earnings that accrue while the borrower's money sits in this bank account belongs to the lender or middleman. When a year has elapsed, an excess amount has accumulated in the account that is equal to a full payment because the borrower has made 26 half-payments (equal to 13 full monthly payments). It is only at this point that the lender or middleman makes an extra payment that depletes their account. This extra payment is all applied to the principal balance. This results in a significant shortening of the loan's term. On a $350,000 6½% 30-year loan, this Standard Biweekly pays off in 24 years and 4 months. This reduction in term of nearly 6 years from the original 30 years is due entirely to the extra payment of principal every year, and NOT due to the more frequent biweekly payments.

This is the most common form of accelerated payment option available from all sources, both bank-direct, and through middlemen. All that I am familiar with require the payment of a setup fee, and some require additional monthly fees.

3. Simple Interest Biweekly

This program combines the negligible benefits of biweekly compounding of interest similar to #1, and the 26 payments per year of #2. A Simple Interest Biweekly mortgage is one on which the borrower—every two weeks—makes a payment equal to half the Standard Monthly mortgage payment, just like the Standard Biweekly in #2. But in this case the payment is applied to principal every two weeks, resulting in biweekly compounding of interest instead of monthly compounding. A $350,000 6½% 30-year loan converted to a Simple Interest Biweekly pays off in 24 years and 2 months. Once again, the reduction in term is due almost entirely to the extra payment of principal every year—NOT due to the shorter two-week interest compounding period.

This payment option is rare. I know of only one lender who does this type of loan, and they charge a fee to set it up.

4. UFF Money Merge Account

United First Financial agents sell a mortgage accelerator product that is not actually an account at all, but instead is a complicated and expensive ($3,500) computer program. The Money Merge Account name refers to a Home Equity Line of Credit that the program requires the user to have. It is the complicated and confusing nature of this system, plus the company's own marketing materials that might lead people to believe that it is the program's advice that is causing their mortgage to pay down faster; but it is actually the fact that the borrower is applying all their extra monthly income towards the mortgage that might cause it to pay off sooner.

5. CMG Homeownership Accelerator®

The CMG Homeownership Accelerator is a mortgage available through mortgage brokers and bankers that can be used like a checking account. It allows the user to deposit their income into the mortgage account which lowers the principal balance. During the month the user pays their bills out of the mortgage account, which causes the principal balance to rise again. Some interest is saved because interest is compounded daily, and some is saved because unspent monthly income left in the account drives the loan principal balance down.

6. DIY - Do-it-Yourself

Borrowers who like the idea of accelerating their payoff need not pay extra for the privilege; they can do it themselves. By making a double-payment once a year—based on the same $350,000 6½% 30-year example—they will pay off in 24 years, 4 months, just as if they had the Standard Biweekly in #2. This idea might appeal to people who receive annual bonuses, or who have seasonal income for example, and therefore might have extra money to apply to their mortgage once a year.

Alternatively, the borrower could choose to increase their monthly payment by adding one-twelfth (1/12th) of the amount of their Standard Monthly payment to each of their monthly payments. Our sample loan would pay off in 24 years, 2 months, just like the Simple Interest Biweekly in #3. This idea might appeal to salaried or wage-earner people who prefer payments that are level throughout the year for purposes of budgeting.

Because these DIY options aren't contractual obligations, the borrower has some flexibility if they need to easily revert back to the (lower) Standard Monthly payment. By the same token, this ease of switching may make it too easy for people who are not disciplined to make extra payments. Borrowers who find it difficult to stick to a DIY plan might consider an alternative payment plan administered directly by their lender.

Next month I'll discuss important reasons why you might NOT want to pay off a mortgage sooner, plus some other mortgage strategies.

Thanks for your interest,

Dan

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Posted by Dan Marchiando on February 5th, 2009 5:27 PM


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