Here are two mortgages: (Loan 1) Standard mortgage for $166,792 at 6% for 30 years with monthly payments of $1,000.00 or (Loan 2) A biweekly mortgage for $166,792 at 6.1% for 25 years with biweekly payments (once every two weeks) of $500. Which mortgage is better? (Note: There are no prepayment penalties for either loan. Meaning that you can pay as much as you wish, at anytime, without penalty.)
- Loan 1 (standard) because the interest rate is lower.
- Loan 2 (biweekly) because you pay off the same amount 5 years earlier
- Both are the same because this is a trick question
ANSWER:
1. Loan 1 (standard) because the interest rate is lower.
EXPLANATION:
Don’t be fooled by the biweekly mortgage. The interest rate is the true cost of the loan. The greater the interest rate, the greater the cost.
So how is it that the biweekly mortgage is more expensive when it pays the loan off 5 years earlier? Because the comparison in this problem is not fair.
To compare the loans accurately, the cash flow must be the same. That means the payment must be the same. Some may say, “But Scott, they are the same! One thousand per month and $500 every two weeks is the same.” They’re not.
Five hundred every two weeks is $13,000 per year (26 biweekly periods per year multiplied by $500). Whereas $1,000 each month is only $12,000 per year (12 months multiplied by $1,000). The biweekly mortgage is really the pay-more-per-month mortgage in this case or $1,083.33 per month ($13,000 divided by 12 months).
If we make a fair comparison, we must apply the same payment to both mortgages. That is, we must ask the question “How long will it take to repay the standard mortgage (Loan 1) by making payments of $1,083.33?”
The answer to that question is 24.55 years or nearly six months sooner than the biweekly mortgage!
For more on biweekly mortgages, see my article Biweekly mortgage may be a rip-off.