Homebuyers who finance their purchase with 30-year mortgages select the 30 year rather than a 15 year because of the lower required monthly payment.
Few like being in debt for 30 years, however, and many seek ways to accelerate the repayment process.
Some lenders offer standardized versions of accelerated loan repayment programs, which I describe below, but astute borrowers can do better by formulating their own plan that is hand-tailored to their needs.
Lender Semi-Monthly Payment Plans
On a semi-monthly payment plan, the borrower’s monthly payment is split into two pieces of equal size, one due on the 15th of the month and the other on the first. While the borrower makes 24 payments a year instead of 12, they add to the same total. However, the lender credits the half payment on the 15th to the balance on the 15th, which reduces the interest due on the first.
While the reduction in interest shortens the period to payoff, the impact is small. On 30-year mortgages with rates of 6 percent or less, payoff occurs after 719 half payments, shaving just one-half of a month off the term.
There isn’t anything wrong with the semi-monthly mortgage, provided that paying twice a month is convenient and you don’t give up anything of value to get it. For example, the borrower with a 30-year $200,000 mortgage at 4 percent who pays $477.42 twice a month gets to a zero balance just half a month early. But if the borrower rounds off the payment to $500, payoff occurs after 659 payments, or 30.5 months early.
Lender Bi-Weekly Payment Plans
A bi-weekly mortgage is one on which the borrower makes a payment equal to half the monthly payment every two weeks. The payment amount on a bi-weekly is thus the same as that on a bi-monthly. But since there are 26 bi-weekly periods in a year compared to 24 semi-monthly periods, the bi-weekly produces the equivalent of one extra monthly payment every year.
This results in a significant shortening of the term.
For example, the 4 percent, 30-year loan converted to a bi-weekly pays off in 310 months — or 25 years, 10 months. The reduction in payoff period is due entirely to the extra payment every year. Payments are credited monthly, not biweekly, so there is no intra-monthly interest savings comparable to that on a semi-monthly.
Note that the benefits of any extra payment program are greater at higher interest rates. The payoff period of 310 months at 4 percent becomes 286 months at 7 percent.
A bi-weekly plan in which payments are credited biweekly rather than monthly would offer little benefit. The payoff period of 310 months cited above would be 307 months if payments were credited bi-weekly.
Roll-Your-Own: The Simplest Approach
Borrowers who like the idea of a simple but disciplined approach to early payoff can do it themselves. By increasing their payment every month by one-twelfth, they will pay off in about the same time as a standard bi-weekly. At 4 percent, payoff is one month later while at 7 percent it is one month earlier.
The major difference between a plan administered by a lender and one administered by the borrower is that the first is mandatory, providing a discipline that some borrowers may value. Doing it yourself means that you don’t have to do it, which is an advantage to some but a drawback to others.
About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.
