13 Oct 2015
Repaying Your Mortgage
Let’s face it, getting a mortgage is hard, but repaying a mortgage is harder. What is the best way to go about repaying? You say, as quickly as I can and with the least amount of interest! Good answer! Statistics tell us most folks repay their mortgage in less than 20 years. Okay how do we do that? First let’s look at how interest is calculated. Many folks think interest is calculated upfront in advance. Not true. Interest is paid in full each time you make a payment and starts accruing the next day until you make another payment. Your payment arrangements could be interest only, principal plus interest or most likely and by far the most common – principal and interest otherwise known as blended payments.
Let’s look at an example:
Let’s say you borrowed $100,000 at 3% interest and agreed to repay over 25 years with equal annual payments of $4,000 per year plus interest. At the end of year one you would pay $4000 plus $3000 interest ($100,000 @3%). At the end of year two you would pay $4000 + $2880 interest ($96,000 @ 3%). At the end of year three $4000 + $2760 ($92,000 @ 3%). This would continue each year until your final payment at the end of year 25 of $4000 + $120 interest ($4,000 @ 3%).
So it is clear that interest is calculated every time a payment is made and more importantly that interest is reduced directly in proportion to the reduced mortgage balance. These are important points as you can use this knowledge and apply to your own mortgage. The earlier you can make principal reductions in the life of the mortgage, the less interest you will pay in the long run. Every little bit helps. Let’s say you make an extra payment of $1,000 in the first year of the mortgage. That is $1,000 you will never have to pay interest on again!
How to pay extra:
The most common method and one heralded as the magic wand is the “accelerated bi-weekly” payment. It is true, it is possible to shave about 3 years off your 25 year mortgage using it. This is a good method and one that should be used, but what if you are not paid bi-weekly? I tell clients they should match up cash flows. Mortgage payments should match up to when you get paid. If paid bi-weekly then b/w payments. Weekly, weekly payments. Twice a month, semi-monthly payments. Monthly, monthly…you get the idea. So Len, how do I take advantage of the “accelerated bi-weekly” strategy if I’m not paid bi-weekly? Ah ha, simple, it’s in the math. Paying bi-weekly is the equivalent of making 13 full monthly payments in the course of 12 months or 1 year.
Let’s look at an example:
You have a mortgage payment of $1000 per month.
$1,000 per month x 12 months = $12,000 per year. We want 13 payments or $13,000 per year.
Bi-weekly accelerated: $13,000/26 = $500 b/w
Weekly accelerated: $13,000/52 = $250 weekly
Semi-monthly accelerated: $13,000/24 = $541.67 1st and 15th of each month
Monthly accelerated: $13,000/12 = $1083.33 monthly
NOTE: It is not how often you pay, it’s how much that counts!
Question: Len, what is a “bi-weekly non-accelerated” payment?
Answer: in the above example, it is the equivalent of paying $12,000 per year, so;
Bi-weekly non-accelerated: $12,000/26 = $461.54 b/w
Weekly non-accelerated: $12,000/52 = $230.77 weekly
Semi-monthly non-accelerated: $12,000/24 = $500 1st and 15th of each month
Monthly non-accelerated: $12,000/12 = $1000 monthly
In this case, you are not paying anything extra towards the mortgage, but you are matching cash flows.
By the way, monthly is the default option for all mortgages. If you were to examine your property title and the corresponding mortgage lien document registered against it, you would see that it is registered with monthly payments. Other payments are options offered by lenders to borrowers “in good standing”.
As always, get independent professional advice on which strategy and options are right for you. Your local independent Dominion Lending Centres Mortgage Broker can help.