The mystique of the bi-weekly mortgage payment

I met with clients over the weekend to do some mortgage planning. They’re buying their first home, and they had lots of great questions about lender options, how to decide between a variable rate or fixed rate mortgage, and the mortgage process. Then they said something I’ve heard clients say hundreds of times over the years: “We’re thinking of doing a bi-weekly mortgage payment. Or even weekly. The more frequently you pay, the better it is, right?”

The answer is…

Yes and no. (Sorry!)

I think the idea that frequent payments = interest savings stems from the idea that if you are lowering the amount you owe, that is, your mortgage principal, more frequently than once per month, then there is less time for interest to add up on that mortgage principal.

And yes, it is a bit true. I think the easiest way to visualize this is by using an example.

Let’s say you are getting a $400,000 mortgage.

I’m going to use a mortgage rate of 2.79% for these calculations.

So the monthly payment on that, if you spread it over 25 years (called the “amortization” in mortgage lingo), works out to $1,850.15.

Over 25 years, the interest portion you pay (assuming your interest rate is always the same) works out to $155,043. Remember this number.

Next, let’s have you pay every two weeks, or bi-weekly. Your payment becomes $853.38. The amount of interest you pay over the 25 years is $154,699.

What the… ?!? That’s only a savings of $344?

Well, it’s true! (Check out the numbers on the Mortgage Architects mortgage calculator if you don’t believe me!)

Here’s why…

The regular bi-weekly mortgage payment is calculated by taking your mortgage amount, and figuring out what amount you’d need to pay bi-weekly to pay it off over the full amortization.

That is, you’re not paying it off early. Which is why you only save a measly $344.

It’s the bi-weekly accelerated mortgage payments that really give you savings to the max.

The bi-weekly accelerated payment schedule is a great savings hack. Instead of having you pay $853.38 every two weeks, the accelerated payment is 50% of the original monthly payment, or $925.08.

What happens if you pay 50% of the monthly payment every two weeks?

Your interest paid over the life of the mortgage ends up being $136,560.  Aha! That’s a savings of $18,483!

You’ll notice I said “life of the mortgage” rather than “25 year amortization”. This is because when you make bi-weekly accelerated payments, you end up paying the mortgage off in 22 years and 5 months, not 25 years.

Why?

Let’s take a closer look at the numbers over one year.

Scenario 1 – Monthly mortgage payments

Over a year, you pay $1,850.15 X 12 (ie 12 months in the year) = $22,201.80.

Scenario 2 – Regular bi-weekly mortgage payment

Over the year you pay $853.38 X 26 (ie 26 bi-weekly payments in the 52 week year) = $22,187.88. Almost the same amount as in scenario 1.

Scenario 3 – Accelerated bi-weekly mortgage payment

This time, over the course of the year, you pay $925.08 X 26 (again, 26 bi-weekly payments) = $24,052.08.

You may notice that the difference in payments you make between scenario 3 and scenario 1 is $1,850.28. Does it feel like you’ve seen this number before? Well, you have, almost…  It’s almost exactly the same as the monthly mortgage payment.

In other words, the bi-weekly accelerated mortgage payment schedule lets you sneak in an extra payment every year.

So, is the bi-weekly accelerated payment always better?

Again, yes and no.

I like the bi-weekly accelerated or weekly accelerated payments for people who get paid bi-weekly or weekly, because it’s very comfortable for your budgeting or cash flow. Every time you get paid, a mortgage payment comes out; super easy.

But if you are only paid monthly, that means there will be months when you get stuck with 3 mortgage payments instead of two.  Unless you have a ton of income to play with, that’s a pain! And those 3-payment months may be hugely inconvenient if you have other things going on in your life.

Similarly, if you are getting this mortgage for an investment property where you are only receiving your rent cheque once a month, or anything along these lines, again it is not convenient to have your mortgage payments set up on a bi-weekly accelerated schedule.

I’m a big believer in making your mortgage work for you, rather than making you a slave to your mortgage.

So how can you get interest savings and still stick with monthly mortgage payments?

It’s simple: take advantage of your mortgage lender’s pre-payment privileges and make an extra payment of at least the same amount as your monthly mortgage payment, each year. Instead of having no control over when you sneak in that extra payment, you decide when to make that extra payment. Some lenders are really flexible and allow you to throw money at your mortgage any time you have an extra $100 or more, as long as you don’t go over the maximum. Others have a minimum $1,000 pre-payment policy. Check with your mortgage professional to know which comes with the mortgage you’re planning to book.

So in this scenario, let’s say that once a year you make an extra payment of $1,850 toward the $400,000 mortgage in these examples.

Run the numbers, and voilà! The interest amount you pay over the life of that mortgage is $137,744.68. (A good calculator that allows you to play with the “extra payment” scenario is at getsmarteraboutmoney.ca.)

This represents a savings of $17,298.32 over the life of the mortgage, compared to simply sticking to the monthly payment schedule. And you pay it out in just over 22 years, rather than 25.

You’ll notice that it’s a bit less savings than if you’d done the bi-weekly accelerated…  If this really irks you, and you have the extra cash, just can boost that extra payment by $150 each year (i.e. $2,000 per year, instead of $1,850). That way, you’ll end up paying a touch less, or $136,521.02 over the life of the mortgage.

Want to dive deeper into these topics?

If you want to check into more mortgage paydown hacks, go to my post on paying your mortgage off fast, here.  And for more on first-time homebuyer strategies, check out my many blog posts, here.

As always, feel free to get in touch to discuss your mortgage plans.

Photo [c] Yulia Gapeenko for vecteezy.com