How to reduce your mortgage interest: The advantages of bi-weekly payments

by John F Mann

One way to save more for the long term is to increase your mortgage payment, compared to the minimum monthly amount. This financial planning strategy reduces total interest you have to pay and shortens the time required to pay off the mortgage balance.

This strategy can be accomplished by adding some amount to every monthly mortgage payment. The added amount could even be varied from month to month. However, unless you have very strong willpower, the bi-weekly payment plan, with constant payment amount, is likely a better way to maintain your initial enthusiasm for this long term financial goal.

Consider the following key points about the bi-weekly payment plan;

1 - The additional amount you pay each year (compared to a monthly payment plan) reduces the total interest you must pay for the mortgage amount borrowed. You also pay off the mortgage much earlier.

2 This plan has the same financial effect as if you deposited the additional amount into a savings account earning the mortgage interest rate.

3 - Effectively, the bi-weekly plan with constant payment amount is simply a "forced" savings plan.

For discussion purposes, the following example will be used to illustrate how the bi-weekly payment plan works, compared to a monthly payment plan;

Total purchase price: $200,000
Total mortgage amount: $160,000
Term of mortgage: 30 years
Annual Interest Rate: 7.00 percent
Monthly payment amount: $1,064.48 (for comparison purposes)

Each mortgage payment (whether monthly or bi-weekly) consists of an interest amount and a principal amount. The interest plus principal always equals the mortgage payment.

The interest amount is calculated by multiplying the effective interest rate (see below) times the current outstanding balance (mortgage amount owed). As the balance declines (due to principal payments) the monthly interest payments also decline.

For a bi-weekly payment plan, there are 26 payments per year (except for once every 11 years when there are 27 payments). For each payment, the effective interest rate is calculated as the annual interest rate (written as a decimal) divided by the number of payments per year.

For the monthly payment plan of our example, the total annual payment is $12,773.76. For the first year, this includes $11,148.52 interest and $1,625.24 principal, which reduces the mortgage balance to $158,374.76 at the start of the second year.

For the full 30 years of the mortgage (using monthly payments) total interest is $223,214.

A bi-weekly payment plan can be structured (over 30 years) that results in essentially the same total interest paid for a monthly payment plan over 30 years. For our example, the bi-weekly payment would be $490.71. This is considered the "minimum payment" for further discussion.

However, other than perhaps the convenience of direct withdrawal from a bi-weekly paycheck, there is no benefit of making only the minimum payment. Since the usual intent of the bi-weekly plan is to decrease the total interest that must be paid for the mortgage, an additional amount must be included.

One way to structure a bi-weekly payment plan is to make each payment equal to half of what would have been the monthly payment. For our example, the bi-weekly payment would then be $532.24, which is about $41 more than the minimum. The annual payment of $13,838.24 (for 26 bi-weekly periods) is then $1,064.48 more than the annual payment using the monthly plan. You are effectively making one additional "monthly" payment per year.

You might round the basic bi-weekly payment ($532.24) up or down to the nearest ten dollars ($530 or $540). Of course, total interest is reduced most by using the largest payment amount.

Using $540 as the bi-weekly payment amount, the total interest is reduced to $160,966, which is $62,248 less than the $223,214 interest for the monthly payment plan. To understand how this occurs, consider that the time required to pay off the mortgage is also reduced to 22 years and 10 months.