If you recently bought a house or re-financed a fixed rate mortgage, more than likely you’ve been solicited by at least one bi-weekly mortgage originator. They claim you can save money and reduce your loan term by signing up for their program. What’s a bi-weekly mortgage all about?
Bi-Weekly vs Bi-Monthly
First, what does bi-weekly even mean? I know bi-monthly means you pay twice a month. So bi-weekly must mean you pay your mortgage twice a week? You’d think, but in mortgage parlance it means you pay your mortgage every two weeks.
Specifically, one-half of your regular monthly mortgage payment is made to your bi-weekly mortgage originator every two weeks. By the end of the year, twenty-six payments have been collected, which is the equivalent of thirteen months of payments.
Those extra two payments are used to reduce the principal balance of your loan above and beyond the loan’s amortization schedule. This results in savings on interest and a shorter loan term, assuming it’s a fixed-rate mortgage.
This is the way most bi-weekly mortgages work. Unfortunately, as with other financial-related products, there’s quite a bit of deception going on here. Don’t fall for it.
Before proceeding, make sure your mortgage doesn’t have a pre-payment penalty. This clause penalizes you when reducing the principal balance on your mortgage faster than the loan’s amortization schedule. If a pre-payment penalty exists, the strategies discussed here won’t work. The good news is, thanks to legislation passed by congress to help protect homeowners, most loans don’t have them, and if it’s a federally backed loan the penalty can’t last for more than three years.
The Bi-Weekly Mortgage Caper
People in the mortgage industry argue that a bi-weekly mortgage is not a scam. I’ll let you be the judge. A bi-weekly mortgage will save you money and cut years off the time it takes to pay off a fixed rate mortgage. That’s true as advertised, but I’ve found most people who sign up for a bi-weekly mortgage think they’re getting a bi-monthly mortgage.
With a true bi-monthly mortgage (good luck finding one), one half your amortized monthly mortgage payment is processed halfway through the month and the other half at the end of the month. With an amortized payment, part of the payment goes to paying interest and the other part to principal reduction. A bi-monthly mortgage processes that first payment on the fifteenth of the month. This reduces the principal sooner than it would with a normal once-a-month schedule, thus you’re charged less interest on that now lower principal balance for the remaining days of the month. This saves you lots of interest over the life of the loan.
A conventional mortgage, per its amortization schedule, credits payments monthly or 12 times during the year. A bi-monthly mortgage credits payments 24 times a year or twice a month. Reducing the principal balance earlier reduces the amount of interest charged on that ever-lower principal balance, thus resulting in an even shorter loan term.
The deception lies in the fact that whoever sold you on that bi-weekly mortgage is hoping you think you’re really getting a bi-monthly mortgage. A true bi-monthly mortgage would pay off your loan way faster and save you even more money than a bi-weekly mortgage.
The fact is, halfway through the month when the bi-weekly mortgage people receive your payment, they don’t process anything. They hang on to your payment until your next payment arrives in two weeks and then make your regular monthly payment to your lender. There is no principal reduction mid-month like with a true bi-monthly mortgage. They ‘ll do this month after month until the end of the year.
Your bi-weekly loan originator all the while is raking in fees for little work. The worst charge you for every transfer made, as well as their initial “set up” fee. All the while, they know you’re probably confused as hell and won’t figure out you can do what they do more efficiently, save even more on interest, and lose the fees.
Standardized Mortgage Payments
In Spending Money, I talk about budgeting and how to use standardized expense categories. If you’re not standardizing your expense categories you’re just pretending to live on a budget. Standardizing involves turning all your periodic and some variable expenses into monthly expenses and is key to managing a tight budget. I want you to do the same thing with your mortgage payment.
Rather than making a principal reduction at the end of the year in the amount of one mortgage payment like the bi-weekly mortgage folks, do it one better. Standardize that mortgage payment.
Start your principal reductions with January’s payment instead of waiting till the end of the year. Divide your monthly mortgage payment by 12. Add the result to each month’s payment. Now that extra principal reduction is done throughout the year one-twelfth at a time rather than all at once at the end of the year. This saves you even more on interest and reduces your payment period even faster. It’s 100% free and takes little effort on your part.
Lump Sum Principal Reduction
Maybe you’re on the richer side, or you got a big year-end bonus or tax refund. Assuming paying off your mortgage is your number one financial goal, pay that principal down all at once by adding that extra one month’s payment to January’s payment. Because you’re reducing your principal balance all at once in January, this strategy is superior to them all: You’ll save even more money and reduce your loan term even faster.
There are parallels to my strategy of paying yourself first here too. Paying yourself first puts your most important money, your savings, to work for you faster by prioritizing saving over spending. Becoming a better money manager means trying to find savings everywhere, and that includes discovering the best way to pay off your mortgage and not getting ripped off.
Is It a Scam?
I know this is confusing. That’s exactly how these bi-weekly loan originators pull off their little trick. They’re counting on you staying confused. Hopefully, now you know better.