More Mortgage Misinformation
An article (April 22, 2004) appearing in a Canadian National newspaper, “When you borrow money to buy, do not overpay” does not live up to its heading as far as the mortgage mathematics is concerned. First of all the author fails to understand most Canadian Banks today use a 365 day year in calculating weekly payment schedules. Secondly the author does not appear to understand the importance of the three types of weekly payments.
The newspaper example is a $240,000 mortgage amortized for 25 years at 4.6% using semi-annual compounding and making weekly payments. His solution (to not overpay) is to lower the amortization period to 20 years and pay the larger weekly payment. Great idea, but the logic is based upon the minimum weekly payment. The net effect is that the ensuing weekly payment (based upon 20 years amortization) ends up being greater than the correct accelerated weekly payment (which is good) so this is an example of two wrongs making a right.
What if you cannot qualify or afford to shorten the amortization period to 20 years from 25 years. Unless you are aware of the three popular types of weekly payments (there are an infinite number of weekly payments) you will not be aware of one of your savings options, that costs you nothing!
360 Day Year
365 Day Year
The oversite, a 360 day year vs a 365 day year, is not critical in his flawed analysis, because the minimum weekly payment quoted understates the savings by an amount of $510 ($1,096.69 – $586.53 ) if the borrower elected to remain with the 25 year schedule while making the minimum weekly payments. What is critically wrong is the author uses the minimum weekly payments in his analysis. He should have informed the readers about the differences in the three weekly payments that are usually offered by the Banks.
Before describing this critical flaw regarding an apparent misunderstanding of the weekly payment plans I will reiterate the only rule to remember to save interest on a mortgage. PAY BACK THE LOAN AS QUICKLY AS POSSIBLE! Prior to the introduction of weekly payment mortgages in Canada (1984) the only way to pay back a mortgage as quickly as possible was to increase the monthly payment, therefore automatically reducing the amortization period. For a given principal and annual interest rate, when the payment is increased the amortization period must decrease according to the laws of algebra. If you decrease the amortization period for a given principal and interest rate the payment must increase according to the laws of algebra. The result is exactly the same. The interest clock is started the moment you borrow money. The sooner you make a payment, the less interest you pay.
By paying weekly payments instead of monthly payments you save on interest because less time has elapsed. Obviously, the amount of the weekly payment is important. Pay the largest weekly payment your budget can afford. The larger the weekly payment , the more dramatic the decrease in the amortization period, according to amortization algebraic laws.
This is the way mortgage should have been handled!!!
You go to the Bank, ask for a loan of $240,000 they offer you 4.6% for 25 years and you initially ask for a monthly payment. They quote you $1341.71 per month and everything is OK. You divide the monthly payment by 4.3333 and arrive at the non accelerated weekly payment of $309.63. You then divide the monthly payment by 4 to arrive at the accelerated weekly of $335.43.
If you pay $1341.71 per month it will take 25 years to pay off the mortgage. If you pay $309.63 per week it will take 24.87 years to pay off the mortgage, BUT you will save $2,032.74 cents for doing nothing, which is why I call it free money! The non accelerated weekly and the monthly is the same amount of money paid back to the Bank at the end of the year. If you pay $335.43 per week it will take 21.59 years to pay off the mortgage and you will save $25,990.19.
MINIMUM WEEKLY PAYMENTS:
$308.78 per week based upon the 25 years and a 365 day year, the $240,000 mortgage would be paid in 25 years and save the lender $1,096.71 over the 25 years. This is the weekly payment that any financial calculator would calculate!
NON ACCELERATED WEEKLY PAYMENTS:
$309.63 per week is based upon the 12 regular monthly payments but paid back weekly (12 x1341.71/52). The savings of $2,032.72 over the next 24.87 years is free money. It’s the same amount of money as paying monthly on a yearly cash flow basis but you are letting them take it out of your account weekly. This is free money. It costs you nothing to save the $2,032.74
ACCELERATED WEEKLY PAYMENTS:
$335.43 per week is based upon 13 times the monthly payments divided by 52 and the savings are $25,990.19 over the 21.59 years.
The weekly payment is not carved in stone and if you told your Banker that you wanted to pay $351.57 per week (above) the correct interest cost would be approximately $125,001, which is a $1000 less than the misinformed writer arrives at. If you want to pay $360 or $370 or $400 per week you can if your budget allows it.
If you are not aware of these three weekly payments you would miss the free money!
Some may say that $2,032.74 is not much however if the interest rate was 12% (and they will be there in a few years) the free money becomes $25,246.53 which is also enough for a new car. And in this example if rates ever go to 20% (as they did in early 1980s) the free money becomes $169,749 which is almost unbelievable.