Spring Mortgage Market Update (2010)May 3, 2010
What’s in the Fine Print?May 17, 2010
There is a stubborn misconception out there that changing the frequency of your mortgage payment, as if by magic, will knock years off your amortization period. Let’s put this belief to the test.
Assume that you have a $300,000 mortgage, with a 25-year amortization and a 5% interest rate that you pay monthly. Your total interest paid over 25 years will be $223,445.97. If you change your payment frequency to weekly and leave all the other variables unchanged, your total interest paid over 25 years will be $222,619.70. That saves you $826.27 over 25 years. Or $33.05 a year. Not a lot of magic there.
So why does this misconception exist? I blame the marketers. Several years ago some bank’s marketing department was looking to add a little sizzle to their mortgage steaks and came up with “accelerated” payments. Here is a comparison of the different payment frequencies using the example above:
- Monthly payment = 12 payments of $1,744.81, which adds up to $20,937.72 annually.,
- Bi-weekly payment = 26 payments of $804.01, which adds up to $20,904.26 annually.
- Accelerated bi-weekly payment = 26 payments of $872.41, which adds up to $22,682.66 annually. This payment is higher because it is set at half of the monthly payment and paid 26 times, which has the same effect as making 2 extra payments each year.
So the accelerated bi-weekly payment does pay down your mortgage faster, but only because it increases the amount of your regular mortgage payment. I think the misunderstanding happens because it is marketed as though changing the frequency of your payments will reduce the life of your mortgage. In fact, it is the increase in the amount you pay that accomplishes this. What many customers don’t realize is that they can increase their mortgage payments any way that they like without using the accelerated payment option: for example, by rounding to the nearest $100, by increasing the mortgage amount so that it accounts for 32% of gross income, or by rounding up to 99 because Wayne Gretzky is your favourite hockey player!
When it comes to your payment frequency, I offer one simple tip. Match the timing of your mortgage payment to the timing of your paycheck. That way, the payment is taken before you wake up in the morning and you never have to worry about being short. As for prepayments, the more you pay, the faster you will be mortgage free. That’s the only reason choosing the accelerated payment frequency option will help you pay off your mortgage faster…except maybe in the land of Honilee.