Bill Merkel: “Thought I’d pass this ‘great deal’ on your way. My mortgage company, Norwest, has been bugging me since I first bought my house to sign up for their ‘convenient’ and ‘money saving’ bi-weekly service plan. They claim that by doing so, I can shave over 6 years off my term and reduce interest payments by about $20,000 over the life of the loan. And it only costs $9 a month. Hmmm, the opportunity cost of $9 a month for 23 years, say at 15%, is about $21,500. So I’ll save $20,000 by [foregoing] $21,500. I think I’d do better by just sending in an extra $9 in principal every month. That math is a bit tough for me, though. Any thoughts on bi-weekly payments?”

A biweekly repayment schedule is a relatively painless way to pay down your mortgage faster, and thus save lots of interest. Instead of paying $1,000 a month, say, you pay $500 every two weeks. There being 52 weeks in a year (and 4.3 weeks in a month — a handy fact many people forget), you wind up make 26 such payments, or 13 months’ worth rather than 12. That extra month’s payment greatly accelerates the pay-off.

Is it worth it? Certainly not if you can earn 15% on your money. But you can’t. At least not over the long run, unless you are a very, very rare individual.

The math here is actually very simple. Paying off, or paying down, an 8% mortgage is the same as “earning” 8% — risk-free — by not having to pay it. That’s a tax-free 8% (not bad!) if for some reason you don’t itemize your tax deductions; or more likely the equivalent of a taxable 8% if you do. (Because after-tax the mortgage interest really didn’t cost you 8% at all, but perhaps 5% — so, after tax, that’s all you’re really saving by paying it down early.)

So if you happen to be the last one on earth with a 12% mortgage, it’s a no-brainer — jump at any early pay-off you can make. But while I think mortgage pre-payments are a decent idea for most people, the case grows ever less compelling as the interest rate goes down. Would you rush to pay off a 3% loan (if there were such a thing)? I hope not!

The fact is, the 7% or 8% that most people could “earn” these days, risk-free, is a pretty good rate. After all, it seemed OK to the people who loaned you the money, and they weren’t naive little savers. Indeed, the people who loaned you the money were likely getting a tiny bit less (the bank, as servicing middleman, takes its small cut), and they were taking at least a teeeentsy bit more risk. (There is almost no credit risk in first mortgages, let alone in buying bonds backed by a diversified pool of first mortgages. But “almost no risk” is not zero risk. And believe me, there is zero chance, if you owe 8% interest on your mortgage, it will be forgiven. So there is 100% certainty that by paying down your mortgage you will save the 8% you would most assuredly otherwise have had to pay. Unless, that is, the bank fails to do its math properly — something to watch out for.)

Accelerating the payments on an 8% mortgage is not a way to grow rich quick, but it is, as I say, a relatively painless way to sleep sounder; an easy form of forced saving.

But what about this $9? At first, I thought it was a monthly principal prepayment, but now that I think of it, I assume it is, as you say, a bank service charge — $108 a year, year after year, to have a computer clerk at the bank click one button, one time, to recast your repayment schedule. (Not to mention the 14 extra payments for you to mail or e-transfer each year — 26 instead of 12 — which may have a small cost to you as well.)

So if you have the discipline to do it, I’d skip the $108 fee and just send an extra principal pre-payment (clearly marked as such on your check!) every so often. For example, you might commit to yourself to send the amount of your entire tax refund each year, if you normally get a tax refund. Check with your bank; but every bank I’ve ever had a mortgage with has handled pre-payments routinely. The extra payment is simply subtracted from the balance due. And without service fees.

 

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