Monday, October 15, 2012
Smart Strategy or a Scam?
Bert Whitehead, M.B.A., J.D. © 2012
Most homeowners have been solicited by their mortgage company or another financial institution with an offer to convert to biweekly mortgage payments instead of monthly payments. The advantage touted for this strategy is saving a heap of interest over the years and reducing the time required to pay off your mortgage by several years. Clients often ask us whether this is a good idea or not. No, it is not smart; it is a scam.
If that is all you need to know, you're done: go on and read something else. If you want to understand why it's not smart, read on!
The math does work: paying half your monthly mortgage every two weeks does pay off your mortgage much faster and does save a substantial amount of interest. It may also be viewed as very convenient since most people are paid biweekly.
Investment Earnings Exceed Benefit of Interest Savings
It is not financially advantageous because it doesn't take into account the foregone investment earnings, which is more than the mortgage interest saved. The reason biweekly mortgage payments reduce interest and the length of the mortgage is that you end up paying an additional month's mortgage payments each year (26 payments divided by 2 = 13 Months). The correct comparison is not between biweekly mortgage payments and monthly mortgage payments. The correct comparison is between the interest expense you could save with biweekly payments and the amount of interest earned if you invest the additional amount you otherwise would be paying on your mortgage.
A Sample Mortgage Situation (or A Case Study)
Consider a 30-year, 4% fixed -rate mortgage taken out 5 years ago by a taxpayer in a 33% federal tax bracket. The taxpayer is offered a deal to switch to biweekly payments which would require a $500 “set up” fee plus half of a month's mortgage payment to start. The interest rate (4.0%) remains the same, but instead of a monthly payment of $763.86, the home owner would pay $381.93 biweekly. This would enable the homeowner to pay off the mortgage in 21 more years (instead of 25) and save the homeowner $42,572 in interest expense. This is the ”pitch.”
To correctly analyze this problem, there are five factors to consider:
1. Normally (but not always) the mortgage company charges a fee of about $500 to set this up for you. This is ridiculous because most mortgages permit prepayments with no additional fee or penalty. If you were to invest this $500 fee at 6.00% for the 21-year mortgage period, it would grow to about $815.
2. The terms of the biweekly arrangement actually require that the payments be made at the beginning of the period, whereas typical mortgages charge the €payments at month-end. If the homeowner invested only one month’s payment at 6% for 21 years, it would earn about $480 in interest.
3. Paying half of the monthly payment every two weeks is comparable to paying 13 monthly house payments a year. If the extra $764 was invested each year instead of being used to pay off the mortgage, it would grow to $30,548.
4. Since home mortgage interest is deductible, choosing to reduce interest by $42,572 over the next 21 years would increase federal income taxes by $12,024, plus the taxes saved would earn $ 7,575 over the 21 years.
5. In total, the $ 51,442 in additional investment earnings generated by investing the money instead of paying down the mortgage is sufficient to pay off the balance of the original 30- year mortgage in full in 21 years and still have $18,262 in cash remaining.
Additional Reasons Why Biweekly Mortgages Are Not Advantageous
In addition, if you were able to invest the surplus mortgage payments in an IRA or other pension each year, you would be able to defer an additional $17,981 in income taxes.
Consider also that mortgage providers generally charge a lower rate for shorter mortgages. So if you wanted to pay off your home in 25 years instead of 30, it would be wiser to arrange that at the outset when applying for a mortgage and take advantage of the lower rate.
In any event I advise clients to keep a longer mortgage on their home because it is your best hedge against inflation. If inflation increases in the next 5 or 10 years back to 5% or 10% as it did during the 70s and 80s, mortgage rates will soar to 9 to14%. You would be pleased to owe the bank a couple hundred thousand dollars at a 4% fixed rate as your money market account is paying 6% or more!
Special thanks to those who collaborated on this blog: Chip Simon, an ACA colleague from Poughkeepsie, N.Y., Al Hoefer, my technical consultant; and Shari Cohen who was the copy editor.