Chapter 20: Bogus Bi-Weekly Payments on Your Mortgage
Are bi-weekly payments on your mortgage a big mistake?
VA borrowers often wonder about bi-weekly payments, a common strategy to accelerate your mortgage payoff. The idea is to make payments every two weeks, rather than once a month, which adds up to making an extra monthly payment each year.
If you’ve read the chapter, Paying “Extra” on Your Loan – Mortgage Rigormortis!, you already know that we are not fans of accelerating your mortgage payments and principal reduction. However, the bi-weekly payment concept and its drawbacks and benefits deserves attention.
Bi-weekly payments are commonly structured as half the amount of a regular required monthly payment. The borrower divides a mortgage payment exactly in half and then pays that half mortgage payment every two weeks. The borrower effectively makes TWENTY SIX bi-weekly payments, equaling THIRTEEN whole mortgage payments over the TWELVE month year.
That is a typical mortgage acceleration: paying off your loan faster than the amortization required for a 30 year loan. Is this a good idea? Would you achieve the same end result by adding 1/12th of a payment onto your normal payment every month? Yes, and you would maintain much more flexibility with your monthly budgeting.
“Bi-weekly payments” often refer to a financial product, typically involving a fee to have a third party company set-up a payment system. Bi-weekly payment products, while still in existence today, were sold more often in the 1980’s and 1990’s by financial services intermediaries. A financial intermediary is someone who is a middleman between a financial institution (such as a credit union, bank or mortgage company,) and a borrower. Intermediaries and the companies for whom they work would make presentations pitching bi-weekly payments as beneficial, claiming:
They are a useful tool that will save you a tremendous amount of money.
It is easier to budget because the payments are smaller.
You will pay off your loan faster, 7.1 years earlier on a 30 year loan.
You save tons of interest expense as you speedily pay down the principal.
You increase equity because you are reducing the principal and thus own more of your house (equity equals the value of property minus the debt owned on that property.)
The Problem with Bi-weekly Payment Products Sold By These Companies
Typically, because of the way the lenders in the U.S. mortgage marketplace structure loans, you are not allowed to pay “partial” payments or split your normal payment in half, twice a month on your mortgage. That is not how the “note” functions on our domestic mortgage products. The note requires that you pay the entire payment, typically on the first of the month. You are of course allowed to pay additional amounts on your mortgage, and we’ll cover some elements of that topic in this chapter.
Remember we said there can be intermediaries who set up this bi-weekly payment program? Those intermediaries—perhaps a mortgage company, perhaps a mortgage broker or even an insurance agent—may sell you a biweekly payment product to manage your payments for you. You might buy into this program because you wish to shorten the length of your mortgage term and save money. And the seller of this program demonstrates how it magically saves you over seven years of payments – wow! The payments would then be sent to an “Escrow Account” at a financial services company.
That company waits until at least a full payment has accumulated in your escrow account, and then it forwards your full monthly payment onto its final destination on the first of the month. Isn’t it odd then, that you will find yourself facing extra charges for this “service” of “letting” you pay down your loan double-quick? In this arrangement, you’ll typically pay a biweekly mortgage conversion set-up fee, which costs between $200 - $500. Then you’ll get dinged again with a transaction fee of $2.95 - $9.95 each time your money is drafted into an intermediary’s escrow account. And there your money will sit until it is time for your mortgage lender to accept it. Absurd!
Our main point of this discussion is that if you are ever approached to pay off your mortgage faster via a bi-weekly payment program facilitated by an intermediary, run away! You can achieve the same result yourself, without all the fees, by simply dividing your required payment by twelve (12) and adding 1/12th of a payment onto each of your monthly payments. The net effect is making thirteen monthly payments in a calendar year.
The Bi-Monthly Mortgage
A “bi-monthly” mortgage could also be called a semi-monthly or bi-monthly payment. This is like the unicorn of American mortgage financing. It’s is so rare we’re not even sure it exists in our highly developed mortgage system. More complicated mortgage products such as these may be available in Canada or elsewhere around the globe. This next concept is important though because of the distinction of how the principal reduction and mortgage acceleration functions.
With a bi-monthly mortgage, you divide your monthly payment in half and make a payment twice a month, one payment on the 1st and the other on the 15th. Over the course of the year, semi-monthly payments result in twenty four payments. As opposed to reducing principal just once a month, and getting charged for interest on that new lower balance on the next payment, a little magic happens! The bi-monthly payments reduce principal twice a month. Because of the principal reduction in the middle of the month, the borrower is then being charged less interest expense between the 15th and the end of the month. This lower interest expense shows up on the amortization schedules for this type of loan.
With a bi-monthly mortgage, the lender would be posting the principal reduction that much faster with twice as many payments during a twelve month calendar. In theory, that would save the borrower a ton of interest expense compared to a normal 30 year amortization requiring only twelve monthly payments per year. This loan product is a rare beast indeed. We’ve never seen it used in the U.S. Again, it may be available in other countries.
Banks and Mortgage Companies Still Love “In-house” Bi-Weekly Payments!
This above heading sounds counter-intuitive based on our previous discussions. However, large lenders love automatic, scheduled payments from you. They love to put you in a “pre-authorized checking draft.” They want to drag your payments right out of your checking account and into theirs. It’s easier for them. They want predictability of payments without having to communicate with you, or having to wait for your money. They don’t want delinquencies, and the last thing they want is foreclosure! They absolutely love it when they can pluck money out your account! That’s why, at the beginning of your new mortgage, lenders will reach out and entice you into a bi-weekly payment program. They want to present to you an “advantage” for having your payments plucked out of your account. This is the same sales pitch as the one coming from an intermediary, but with a different motivation.
The lenders also like the bi-weekly because they are conceivably making money on the “float.” They have your extra money in their coffers while it waits to be applied to your monthly payment. They are doing the same thing that the old third party administrators were doing. They are drafting right out of your checking account:
On the 1st.
Again on the 14th.
Again on the 28th.
And applying the full payment on the 1st of the next month!
The key to the success of a bi-monthly payment schedule is all about crediting that principal at the beginning AND during the middle of the month, something that doesn’t happen with any of the bi-weekly programs available at the banks and mortgage companies. Because the principal isn’t getting credited at twice the frequency, you are not getting the benefits that would accrue, given the correct mathematics.
If you find that you are being charged a service fee just to pull your own money out of your checking account—to heck with that! That’s robbery. Avoid bi-weekly products that charge you scads of money for something you could do yourself. If you’re looking to pay more on your mortgage to get ahead, then take the money you would pay in service fees and apply them to your mortgage and accelerate it that way!
Some VA borrowers who favor bi-weekly schedules are those people who get paid every two weeks as opposed to twice a month on the 1st and the 15th. There is a subtle difference here being paid TWENTY SIX times a year vs. TWENTY FOUR times a year! In our experience, these folks get easily enticed into these programs and adopt a bi-weekly payment schedule because it seems to make budgeting more manageable. If you fall into this category, just be realistic of how this game works and why it exists.
For assistance on which type of payment plan works best for your mortgage payment, let So Cal VA Homes help. Call us at (949) 268-7742.
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