A few years back, it became popular to reduce the interest expense of a home mortgage by dividing the monthly payment in half and making two payments each month. This also helped those on a budget align the timing of their expenses and with the timing of their paychecks. While I don’t hear about this approach as often these days, it’s still a good idea, so I thought I’d explain how it works.
Intuitively, you must wonder: if I pay the same amount of money each month overall, but just split the payment into two installments, how can that save me thousands of dollars over the life of the loan? It basically comes down this: you’re making one additional payment each year.
If you have a 30-year loan of $100,000 with a 4 -percent interest rate, your regular monthly payment would be about $480. At the end of 30 years if you make 12 payments per year, you’ll end up paying back the $100,000 loan plus another $72,000 in interest. If instead, you pay $240 every two weeks, you’re paying the equivalent of $520 per month because of the timing of the payments adding one full payment per year. The higher payment means you’ll pay the loan off sooner—in this case, four years sooner for a net savings of $11,000 in interest over the life of the loan. As the interest rate goes up the savings increase geometrically – at 6 percent (a 50 – percent rate increase) you save more than $24,000 (a 127 – percent increase).
For most conventional home loans, you can pay up to 20 percent of the loan value each year without pre-payment penalties. This allows you to save interest over the life of the loan, but does not obligate you to make the higher payments. Of course, it’s a double-edged sword: if more immediate spending options lure you away from your long-term financial goal of paying your mortgage off early, no one is there to force you to stick to your original plan.
Another way to achieve a similar result (that forces you to make the higher payments) is to start with a 15-year loan rather than a 30-year loan. This has two advantages: you pay off the loan more quickly and the loan can usually be obtained for ¼-percent to ½-percent lower interest rate.
Whether you choose this approach should depend on alternative uses for your money. If the higher mortgage payments make it impossible to send junior to college or replace your 15-year-old clunker, this may not be a good option for you right now.
There is a way to get the best of both worlds: take the 15-year mortgage (if you can pay more in the short run), and as equity in the property increases through the down payment, appreciation of the property or amortization of the loan, talk to your local bank about a home equity line of credit (HELOC).
A HELOC allows you to put more money toward your mortgage while still maintaining your access to cash if you need it. All of this assumes you’ve maxed out other investments with higher returns than your mortgage, like maximum contributions to your retirement account, for example. The HELOC option is a good idea if your budget will allow a higher payment. But do make sure you’re wise about it. If you have a rotating credit card balance getting charged at 22 percent, pay that off first. That interest is much higher than a home loan and isn’t tax deductible.
If you’re in the process of buying a house, your realtor can explain the ins and outs of a 15-year versus a 30-year loan. Don’t hesitate to ask!
If you have questions about real estate or property management, feel free to contact me at rselzer@selzerrealty.com or visit our website at www.realtyworldselzer.com. If I use your suggestion in a column, I’ll send you’re a $5.00 gift card to Schat’s Bakery. If you’d like to read previous articles, visit my blog at www.richardselzer.com. Dick Selzer is a real estate broker who has been in the business for more than 35 years.