Ah Yes, the argument for and against doing a bi-weekly mortgage payment plan. If you’re not familiar (although most folks are), here’s a little primer. If you check out Summit Mortgage, you will find out that a bi-weekly mortgage payment plan usually involves pre-paying your mortgage by paying ½ of a monthly payment every two weeks. For those keeping score, because there’s 52 weeks a year (26 “bi-weeks”) then you’re making 26 half-payments per year, rather than 12 full payments. This amounts to making an additional half a mortgage payment every six months.
This is a popular idea. So popular that it was even pitched to us by our real estate agent (“It’ll knock six years off your mortgage!”). I was intrigued. But, then we moved in, and the mail started coming in… Here’s a great resource to benefit from.
In my experience, if you get five letters a day from companies suggesting a “no-brainer” idea like home warranties, security systems, vehicle maintenance warranties, and now, bi-weekly mortgage payments—then it’s probably reasonable to think that all these folks aren’t sending you these letters in just good faith and charity. It sends up a red flag. As Henry Fonda says in 12 Angry Men, “Everybody sounded so positive, you know, I… I began to get a peculiar feeling… I mean, nothing is that positive.”
And so as it goes with bi-weekly mortgages, I wanted to get to the bottom of it—for me and, now, for you, so let’s start here and work this through.
A bi-weekly mortgage is nothing more than sending half-a-month’s mortgage payment to a third-party (sometimes your lender offers this, but usually not, and even then it makes no difference in the math). Let’s call this third-party company Float, Inc. So Float takes your first half-payment (around about the 7th of the month), throws it in a money-market account for three weeks, collects the interest, takes your next payment two weeks later, puts that in a money-market account, and then on the following 1st of the month, sends both payments to your lender. Every six months there are three payments rather than two, but the process for them is the same (take payment from Hector Homeowner, collect interest, send payment to Hector’s lender).
Talk about a great business model! Random homeowners give Float an interest-free loan for a few weeks every month—no risk, pure profit on the interest. My thinking, let’s just cut out the middle man. I’ll hold onto my money for those few weeks, collect my interest, then make the payment myself.
Now, we’re talking small change here. My mortgage payment is $2650/month. So, in an average month I’d float $1325 for 23 days, $1325 for 9 days, and $221 for 1 day. Insourcing this work, even If I have a high-yield savings account of 1%, my yearly interest is only about $13.30. This might be a small price to pay to force myself into a routine that saves me big over the long haul. However, the interest on the deposit is only half the equation.
The other half of this delves into what is likely the biggest argument man has faced since “White or Wheat?”—and that is, should I prepay at all?
Johnny Moneyseed does a nice number on this topic, but I think I can expound on that.
Take a look at the below chart. The vertical axis is the number of years to pay off a mortgage. The horizontal axis is the interest rate on your mortgage. The green line is the guy who makes his monthly payment and does nothing else. The red line is the guy who makes bi-weekly half-payments. The blue line is the guy who makes the standard payment and invests those pesky “bonus” half payments every six months in an set-aside account yielding 6% per year (50/50 stock/bond mix), and the blue guy pays off his mortgage when that set-aside account balance is higher than his remaining mortgage balance.
What’s the takeaway? First is that a bi-weekly mortgage plan at today’s uber-low prime 30-year rates will really only save you 4-4.5 years on your mortgage. Otherwise, no surprises really. Prepaying a mortgage is just like taking on a risk-free investment that returns the equivalent of your after-tax mortgage interest rate. Conversely, if you can invest at a rate higher than your mortgage, then it makes sense to invest rather than prepay. In the graph’s hypothetical, my set-aside investment account returns 6% per year, so that’s point of indifference between prepaying the mortgage or setting-aside for investments (hence why the lines cross here). If my portfolio had a lower expected return, then the blue will rise and I’d be indifferent at a lower mortgage rate.
Over a 20-30 year period (our mortgage period), most of the volatility in the stock and bond markets evens out, and one can generally expect to return annual historical averages of 3% in bonds, 9% in stocks. So, in almost all cases, it behooves you to invest your dollars rather than prepay your mortgage (via a bi-weekly plan or otherwise).
So, should you repay?
If you can answer “Yes” to the following four questions, then you can prepay on your mortgage. Please note, if you are paying PMI, then disregard these questions, as you should obviously pay down that MoFo until you alleviate yourself from that burden.
1. Do you have less than 10 years remaining on your mortgage? (In short timeframes, market returns are more volatile.)
2. Is your mortgage rate is higher than 4%? (Lower than this and it makes more sense to just invest in long-term treasuries, even if you’re near the end of your mortgage.)
3. Do you obtain some great psychological benefit from owning your home outright? (If not, then just hold a mortgage balance for as long as possible.)
4. Is your home’s value is less than 20% of your net worth. (If it’s more than this you’ll be too concentrated in your asset mix).
I’m curious to hear any feedback on these contentious topics. Thank you for reading!
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