by Gary Foreman
How Mortgage Prepayments Work
Biweekly Mortgage Payment Programs
Dear Dollar Stretcher,
I just received something in the mail saying that if you break up your mortgage payments into twice monthly payments that it helps you pay off the loan faster. So instead of paying our $2,000 per month payment, we would pay $1,000 twice a month and end up cutting 7-9 years off our mortgage. I know better than to pay someone $200 to set up something that I can do on my own, but I was wondering if what they said was true? Any advice?
Pam has an opportunity to save thousands of dollars. But, she's also recognized that she can waste some money here, too.
Let's start with a couple of facts to help understand the issue. The first thing to recognize is that a lot of your mortgage payment doesn't reduce the amount that you owe. All it does is pay the interest that you're being charged each month. That's especially true in the early years of a mortgage.
For instance, at current rates (6.75%) you will make payments for a full year to reduce the amount you owe by 1%. So in one year Pam will have paid $24,00 and still owe 99% of the principal amount.
Paying twice a month will only do a little to reduce Pam's mortgage. The idea is that making a half payment midway through the month will reduce the amount of interest owed. And with less interest owed, more of your payment will go to reducing principal each month.
There are two problems with this approach. First, you're not really doing much to reduce the principal or the amount of interest that you owe each month. Second, many mortgage companies will just credit any early payment to the next payment that you owe and not even give you credit for being early. In that case there's no financial gain.
Paying twice a month will not reduce Pam's mortgage by 7 years. It would only reduce the term of the loan by a matter of months. But there is a way that Pam can get this strategy to work for her.
Instead of paying twice a month, some people adjust their schedule to pay half of their regular mortgage payment every two weeks. That may be what the company is proposing to Pam.
It doesn't seem like much, but at the end of the year you would have made 26 half-payments or 13 full payments. And that's one additional full payment each year.
That one additional payment will reduce the loan term by five and a half years. So the strategy can work. But it's not necessary to pay someone to achieve this result.
All Pam needs to do is to add a little extra to her payment each month. In fact if she can add just 1/12th to each payment, a 30 year mortgage will be paid off 6 years early. All Pam needs to do is to add $166 to her $2,000 a month payment.
Prepayments will reduce the length of your mortgage dramatically. Especially if you make them in the first few years of the mortgage. That's why 15 year mortgages are popular. A relatively small increase in monthly payment can build a lot of equity in your home.
And there's no requirement that Pam prepay every month. Even if she misses many months, any prepayment that she has already made will still reduce the length of her loan.
What's the advantage of a service to handle prepayments? They track two things for customers. First, they verify that the mortgage company applied your prepayment to reducing principal. They also provide current information about your mortgage balance.
Both of those tasks are important. Mortgage companies make mistakes. And in this case any mistake works to their advantage. It's easy for them to take your prepayment and apply it to your next monthly payment. That would eliminate the benefit to you.
Pam doesn't need a tracking company if she's willing to do a little bit of work. Begin by checking with your mortgage company to make sure that prepayment of principal is allowed. In almost all cases it is, but she needs to make sure. Also find out if you need to do anything special when you send it in.
Second, send any extra payment with a clear notation that the extra is to be applied "to principal reduction". Finally, check your mortgage balance after each prepayment to make sure that it was applied properly to reducing principal. A simple phone call should handle it.
Pam has an excellent opportunity to reduce the long term cost of her home. This is definitely a case where a little sacrifice now can pay big dividends later. Although it's hard to imagine being without a mortgage payment, if you plan on owning your own home for 15 to 20 years, it's a goal than can be reached.
Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. Gary is available for audio, video or print interviews. For more info see his media page.