Save big on your mortgage
Bi-weekly payment plans yield big rewards, but aren't suited for everyone.
NEW YORK (CNN/Money) - In today's uncertain economy, where Wall Street is listing and layoffs are rampant, the prospect of a smaller monthly mortgage holds particular appeal.|
Many homeowners, for example, are making the most of the low interest rate environment by refinancing to trim their payments or shorten their term. Some are downsizing to smaller pads.
But if you're looking for long-term strategies that can save you a bundle, you might also consider bi-weekly payment plans. Such pre-payment schedules, whether formally constructed or implemented on your own, can typically save you 25 percent to 29 percent in interest over the life of your loan. It also can shave years off your mortgage.
"If you're making a pre-payment on your mortgage principal, ultimately you'll pay less interest," said HSH Vice President Keith Gumbinger.
There is no free lunch
Bi-weekly payment plans are fairly simple. You pay the bank half of your monthly mortgage bill every 14 days. In other words, rather than paying your bank $2,000 every month, you'd pay $1,000 every two weeks.
By doing so, you end up making one extra monthly payment per year. How you ask? Here's how it works: When you pay your mortgage monthly, you make a total of 12 payments per year. But because of the odd number of days in certain months, there actually are 52 weeks on the calendar. That means by paying every other week you make 26 half-payments, or the equivalent of 13 full mortgage payments per year.
Making extra payments every year costs you more upfront but you save more in the end. And the bigger your monthly mortgage the more you sock away.
For example, a homeowner with a $200,000 mortgage at a fixed 7.5 percent rate would save $76,000 by implementing a bi-weekly payment schedule. His friend with a $400,000 home would save $153,000 on a bi-weekly plan, and his boss with a $600,000 loan would save $229,000 assuming the same interest rate. All would trim about 6 years off the life of their loan.
Does it pay to pay?
Impressive numbers, to say the least, but does it always pay to pre-pay your mortgage?
"This is a conversation I have with clients all the time," said Evan Snapper, a senior manager at Ernst & Young, who notes that drawbacks do exist.
When you pay your mortgage early, for example, you reduce the interest you owe. But you also trim potential tax breaks since mortgage interest is deductible. In other words, prepayment savings don't equal your interest rate, but rather, your interest rate minus tax savings.
So break out your calculator before taking the plunge.
The first step is to determine what your mortgage really costs. The higher your tax rate, the less your interest costs you after-taxes. For example, someone in the highest tax bracket, 38.6 percent, with an 8 percent mortgage pays just 4.9 percent in interest when you factor in tax savings. That same mortgage for someone in the 27 percent bracket costs 5.84 percent after the deductions.
You can do your own calculation easily enough. Start by subtracting your tax rate from 100 to get your inverse tax rate (100 - 27 = 73), then multiply that figure by your mortgage interest rate. (73 X 8 = 584). Multiply the answer by .01 and that's your real interest cost. (584 X .01 = 5.84 percent.)
(To compute how much in interest you ultimately will save, however, you'll need a calculator that can amortize. Download one that allows for bi-weekly payment options at http://www.hsh.com/calc-amort.html#calc.)
Weighing your debt
Once you've calculated your true mortgage costs, you've got to weigh that figure against your other debts.
Paying your mortgage early is a guaranteed investment, one that yields bigger savings than certificates of deposit or money market funds. But financial experts agree it's generally a good idea only after you've paid off other high-interest, nondeductible debt first. That's especially true if you have credit card bills, on which you're paying double-digit rates.
"Pay the mortgage off last," said Snapper.
(Find out how much house you can afford with our Mortgage Qualifier tool.)
You may do better over the life of your loan by investing extra cash in high-yield investments instead, including individual stocks and mutual funds. But bear in mind that you incur risk that way, too, and you will owe taxes on any investment gains.
And don't forget that when you pay off a mortgage, you reduce a potential source of deductible cash: You would be able to deduct interest on a home equity loan only up to $100,000. If you borrow equity before your home is paid for, however, you can deduct interest up to the outstanding balance of your mortgage, plus $100,000.
Moreover, you should not prepay your mortgage at the exclusion of other goals, experts say, such as saving for retirement, funding a six-month emergency fund or setting aside money for your children's college education.
The sleep factor
If you do decide to pay on a bi-weekly schedule, be sure you stick with the plan and be sure you're looking to stay in your home long enough to make the sacrifice of extra payments worthwhile - a 10-year time horizon is reasonable.
Check, too, with your lender to make sure there are no prepayment penalties involved and don't forget to specify that the extra money you're sending in each month should be applied to the principal. Your lender might otherwise use it to pay off interest, yielding no benefit to you.
A final word of caution: Those who are paid once a month, including some public school teachers and military workers, sometimes find it tough to manage their money if they lock themselves into paying their bills every 15 days. Same goes for the self-employed, who can't always estimate their cash flow from month to month.
If you do want to prepay your mortgage, you can achieve the same results by adding the equivalent of 1/12 of a month's mortgage bill to your regular monthly payments.
Snapper said the biggest benefit of being mortgage-free can't be quantified in dollars.
"I call it the sleep factor," he said. "You can rest knowing that God forbid you lose your job or something happens, your home is secure."