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April 14, 2004
"Is there any type of
mortgage that is particularly vulnerable to abuse?"
No mortgage is abusive in itself. However,
the more complicated ones offer more opportunities for unscrupulous loan
providers to take advantage of unsophisticated borrowers. Adjustable- rate
mortgages (ARMs) are complicated, as are fixed-rate mortgages (FRMs) with
special features.
One such FRM, the simple-interest biweekly (SIBW), is the subject of this article. Over the years, many borrowers have
written me about the wisdom of refinancing their mortgage with an SIBW offered
by one major lender. In all cases reported to me, the interest rate on the new
SIBW would be higher than the rate the borrowers were paying on their current
loan. In every such case, I advised against the loan.
In a financial emergency where a borrower
needs either additional cash or a lower monthly payment, it might be necessary
to refinance into a higher rate mortgage. If the objective is to lower interest
cost, however, refinancing at a higher interest rate is never justified.
There is always a better option.
The SIBW loan reps argue to the contrary. The
important thing, they say, is not the interest rate but the total amount the
borrower actually pays in interest over the life of the loan. They then show
that interest payments will decline if the borrower shifts to their SIBW.
Here is a typical case relayed to me by a
reader who had a 6.60% mortgage with a balance of $200,000 and 300 months
remaining. The SIBW lender offered to replace it with their SIBW at 8%. Its
exhibit showed a substantial decline in interest payments.
I developed a spreadsheet to verify this,
which is available on my web site. It shows that interest payments would indeed
fall, from $208,881 to $200,986, or by $7,895.
The largest part of this decline is due to
the biweekly payments on the SIBW. Paying half the monthly payment every two
weeks results in 26 half payments, the equivalent of 13 full payments per year.
The extra payment shortens the period to payoff, lowering total interest
payments. This more than offsets the effect of the higher rate.
However, borrowers need not pay a higher
interest rate to switch to a biweekly. Many programs are available that will do
this for $200 or $300. If the borrower with the $200,000 mortgage at 6.6%
switched to a standard biweekly, total interest payments would fall to $169,614,
or $31,372 less than the SIBW at 8%.
An even better way to reduce total interest
payments over the life of your loan is to increase the monthly payment by 1/12,
which also results in one extra payment a year. You need no one�s permission
to do this, and because the extra payment is credited at the end of the month
rather than at the end of a year as on a standard biweekly, the reduction in
interest payments is even larger. Total interest payments would fall to
$167,849, or $33,137 less than the SIBW.
The SIBW is simple interest as well as
biweekly. The advantage of this is that the biweekly payments are credited
biweekly, as compared to monthly when you increase the monthly payment by 1/12,
and annually on a standard biweekly. However, this saving is small, and the
total interest payments of $200,986 on the 8% SIBW already include it. A
standard biweekly at 8% would have payments of $204,471.
The down side of simple interest is that
borrowers pay additional interest for every day the payment is late. There is no
grace period, as there is on standard mortgages. The figure of $200,986 for
total payments on the SIBW is almost certainly too low because it assumes that
the borrower makes every payment on the first of every month.
Bottom line, the SIBW at a higher rate than
you are currently paying may reduce your interest payments, but by substantially
less than a standard biweekly or a 1/12 payment increase at the same rate.
The SIBW will be called something else, but
you should have no difficulty recognizing it:
- The interest rate will be higher
than rates available from other sources, and probably higher than the rate
on your current mortgage.
- It may be offered as part of a
"free" financial plan.
- The sales pitch slanders
conventional loans. One reader was told that conventional loans calculate
interest every month on the original balance. Another reader was told that
extra payments on conventional loans were not credited until the end of the
loan�s life. Both statements are false.
- The sales pitch usually includes
reference to "reamortization", allegedly available only on the
SIBW. The word means nothing.
Any of these indicators should cause
you to run like a thief.
Copyright Jack Guttentag 2004
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