The Cost of Getting Distracted

January 8, 2001 "We just refinanced our 1st mortgage for $138,393 at 8%, our 2nd for $37,987 at 12%, and one credit card for $7,438 at 10%, into a new simple interest 1st mortgage at 10.14%/10.52%APR. It is a biweekly that will be paid off in 19 yrs 8.4 months without making additional principal payments. How much better is the simple interest loan?" You are asking the wrong question at the wrong time. You should be asking whether to do this deal, and you should have asked it before the deal was done. You paid at least $6,000 out of pocket for the privilege of converting three separate debts with an average rate of 8.91% into a single debt at 10.14%. That is a loser big-time. The present value of all the additional interest you are going to pay over the next 19 years 8.4 months is greater than $20,000 � a stiff price for having to write only one check instead of 3. I can�t be sure what you were thinking because you haven�t replied to my question, but I can make some guesses based on what other borrowers in similar situations have told me. Guess one is that you were focusing too hard on the monthly payment. The new payment is a little lower than the sum of the three old ones, despite the higher rate, because the new mortgage has a longer term. But the higher rate and longer term mean a much slower pay down of the loan balance. My second guess is that you were distracted by two gimmicky features of the new loan: biweekly payments and simple interest. These features added no value to your new loan, but they may well have distracted you from what was important: the high interest rate. Biweeklies pay down the loan balance faster, but only because you are making an additional monthly payment every year. Paying half the monthly payment every two weeks means that you are making 13 monthly payments a year instead of 12. You could have done that, or something equivalent, with your old mortgage. For example, increasing every payment by 1/12 of the payment (for example, a $600 payment becomes $650) accelerates the reduction in loan balance in much the same way as a biweekly. On a standard mortgage, increasing your monthly payment by 1/12 will pay off a few months earlier than a biweekly. The increase to the monthly payment reduces the balance by the same amount every month, but on a biweekly the extra payments are not applied to the balance until they accumulate to a full payment, which takes a year. With a simple interest mortgage, however, the biweekly payments are credited immediately. The upshot is that a biweekly with simple interest will pay down in exactly the same way as a standard loan on which you increase your monthly payment by 1/12. I have railed against biweeklies in the past because so many consumers are conned into believing that they must pay for something that they can do for themselves. In your case, it appears as if the biweekly/simple interest combination was used to distract your attention from the really important part of the transaction � the interest rate. Copyright Jack Guttentag 2002

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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