One of the biggest misconceptions about paying down mortgages is the notion that if you pay weekly, biweekly or twice a month instead of paying your mortgage monthly, you will save a lot of money. To illustrate my point, let's take a look at three brothers – Mark, Tony and Bill. Let's assume they each have a $100,000 mortgage amortized over 25 years at 6%. Mark elects to pay his mortgage monthly, Tony pays his mortgage twice a month and Bill elects to pay his mortgage bi-weekly. Let's see how the brothers fared after 25 years.
Monthly vs twice a month
On Mark's $100,000 mortgage, he pays $639.81 per month. After 25 years, he will have paid off that $100,000 by making a total of $191,943 in payments.
Tony, on the other hand pays twice a month. If Tony pays exactly half of Mark's payment, he would pay $319.91 twice a month instead of paying $639.81 and he would save a whopping $547 of interest over 25 years. Paying more frequently does not make a significant difference.
Does bi-weekly make a difference?
Let's bring Bill into the picture. Bill makes bi-weekly payments which means he will make 26 payments over the course of a year. If we simply take Mark's monthly payment of $639.81 he would pay a total of $7677.72 over the year. If we take $7677.72 and divide by 26 payments, Bill would have to make payments of $295.29 every 2 weeks.
By making more frequent payments of $295.29 every 2 weeks, Bill will save more than twice as much as Tony with $1248.60 in interest saved over the 25-year amortization period. But again, the savings is still pretty insignificant.
Three ways to pay less on your mortgage
Paying your mortgage more frequently does save you some money but real benefit comes in three other strategies.
- Lower interest rate. In the example of the brothers, I used a 6% interest rate. Using a 5% interest rate figure will save the brothers up to $17,480 of interest over the 25 years. That's much more significant than the $500 to $1500 we were talking about by paying more frequently. To get lower rates, consider shopping around for the best rate, barter with your institution for a lower rate or consider shorter-term variable rates instead of locking in for the long term.
- Shorter amortization. Most people stretch out the amortization period for as long as they can to keep payments as affordable as possible. Let's look at Mark again with his $639.81 monthly payments based on a 25-year amortization. On a 20-year amortization, Mark's payments would go up to $712.19 per month. With higher monthly payments, Mark would save over $21,000 in interest on the same $100,000 mortgage. If keeping payments the same were important, Mark could go out and borrow $90,000 on a 20-year amortization instead of $100,000 on a 25-year amortization and have the same $640 per month payment. I guess the point here is to live within your means and buy a house or condo you can afford.
- Extra payments. Let's look at Bill's situation again. If Bill paid the same $319.91 bi weekly payment as his brother Tony (instead of $295.29), he would save $16,951.20 of interest over the amortization. Now that's significant. The difference in interest savings comes from the fact that Bill makes two extra $319.91 payment every year. In fact those extra payments will help Bill to pay off his mortgage 4 years sooner than his other brothers.
Most mortgages have provisions to allow for extra payments like doubling up payments or paying an extra lump sum towards the principal balance. Whatever the case, making extra payments makes a huge difference to paying down your mortgage faster and paying less interest to the banks.
Combining these strategies can make an even bigger difference. The good news is it doesn't take much to make a big difference in savings. All it requires is a little discipline to become mortgage free a lot faster.