The 30-year fixed-rate mortgage is a great instrument that has made home ownership possible for millions of consumers, but none of them like the idea of being in debt for 30 years. Those who like it the least and have the poorest understanding of how mortgage amortization works are vulnerable to payoff scam artists, who keep popping up with allegedly easy ways to pay down the balance faster.
It has been a while since I last wrote about these schemes, but some recent developments provoke me to do it now. In recent weeks, the Consumer Financial Protection Bureau has taken legal action against Nationwide Biweekly Administration “for luring consumers with false promises of mortgage savings.” And Wells Fargo, the largest mortgage lender in the country, has rolled out a weekly payment program that deserves careful scrutiny.
THE BASIC ARITHMETIC OF MORTGAGE REPAYMENT
The basic arithmetic of mortgage repayment is not rocket science, and if you understand it, you will be invulnerable to deception. Let’s assume you have a 30-year mortgage on which the current balance (the amount you owe) is $100,000. The annual interest rate is 4 percent, and the monthly payment due July 1 is $477.42. The interest portion of that payment would be $333.33. When the lender receives your payment, he takes that amount as his interest earnings, and the $144.09 that remains, called the “principal,” is used to reduce your balance. After 359 more payments of $477.42, the balance hits zero. That’s why it is called a “fully amortizing mortgage”.
There are only two ways to speed up the process. The main way is to increase the monthly payment. For example, if you raise your monthly payment by $100 to $577.42, your balance will hit zero in month 259 instead of month 360.
The second way to speed up the process is to have the lender credit your payment earlier. The savings from this technique are small. For example, if the payment due July 1 is credited to your account on June 1, you will save the interest on the principal payment of $144.09 during June, amounting to 48 cents.
Large savings require larger payments. The trick is to find a pattern of extra payments that you can live with. Calculator 2a on my website allows you to experiment with different combinations of payments, payment intervals and payment periods, and see the impact on the amortization schedule, payoff date and total interest paid.
THE BIWEEKLY MORTGAGE
By far the most common scheme for speeding up the payoff process is the biweekly mortgage, where the borrower makes half the monthly payment every two weeks. Since there are 26 biweekly periods in a year, borrowers who do this are making the equivalent of one extra monthly payment every year. If the mortgage described above was put on a biweekly basis at the start, it would pay off in 312 months and save $10,736 in interest. These numbers come from calculator 2b on my site. This calculator assumes that the lender credits payments monthly. If the lender credits payments every two weeks, adding earlier credits to increased payments, payoff occurs in the 310th month and interest savings amount to $11,276. These numbers come from my calculator 2bi.
Borrowers don’t need any help in setting up a biweekly payment plan. All they have to do is set up a special bank account into which they make their half-payments every two weeks, and out of which they make their monthly payments to the lender when due. If they want to avoid the extra step each month, they can instead increase their regular monthly payment by 12 percent. The results will be almost identical to those using a biweekly.
DON’T PAY A BIWEEKLY ENABLER
Paying a third party to receive the biweekly payments and pass on the monthly payment to the lender is not smart because the third party will walk away with most of the interest savings. This is the claim made recently by the Consumer Financial Protection Bureau against Nationwide Biweekly Administration. According to CFPB, the setup and processing fees charged by Nationwide ate up most or all of the interest savings earned by many borrowers who participate in their program.
WELLS FARGO’S WEEKLY PAYMENT PLAN
When I last looked at weekly payment plans a few years ago, they offered nothing to the borrower except the convenience of paying weekly, for which they were charged a small fee. A new plan by Wells Fargo is more attractive because, in addition to the convenience of weekly payments, it adds a payment increase similar to that on a biweekly plan, and there are no fees. The fully amortizing monthly payment divided by four is paid weekly, which results in four additional weekly payments (equivalent to one additional monthly payment) a year. The four additional payments are credited to the balance at staggered weekly intervals throughout the year. The result is the same as the accelerated reduction in the balance that results from adding 12 percent of the monthly payment to the payment every month. Of course, to use this program your mortgage must be serviced by Wells Fargo.
CAN YOU ROLL YOUR OWN WEEKLY PAYMENT PLAN?
You can, but it would be a hassle. You would pay one-fourth of your monthly payment into a bank account every week, withdrawing the scheduled monthly payment within the first 10 days of each month, and adding the four additional weekly payments to your monthly payment when doing so will not leave you short on your next monthly payment. Increasing the size of your monthly payment by 12 percent is a lot easier.
ABOUT THE WRITER
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
©2015 Jack Guttentag
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