Don't Refinance Into a Simple-Interest Biweekly
April 14, 2004, Revised July 6, 2007
"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.
The adjustable-rate mortgage (ARM) most vulnerable to abuse is the option ARM, about which I have written several articles. See Option (Flexible Payment) ARMs.
The fixed-rate mortgages (FRM) most vulnerable to abuse is the simple-interest biweekly (SIBW), which 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 in Spreadsheets, scroll down to Biweekly Payments. 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 Simple Interest Feature
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.
Recognizing the Scam
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.
"Is there any type of mortgage that is particularly vulnerable to abuse?"
Complicated Mortgages Lend Themselves 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.
The adjustable-rate mortgage (ARM) most vulnerable to abuse is the option ARM, about which I have written several articles. See Option (Flexible Payment) ARMs.
The fixed-rate mortgages (FRM) most vulnerable to abuse is the simple-interest biweekly (SIBW), which 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.
Paying a Higher Rate to Lower the Cost on an FRM Is Never Justified
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.
The SIBW Lowers Interest Payments Less Than Other Biweeklies
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 in Spreadsheets, scroll down to Biweekly Payments. 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 Simple Interest Feature
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.
Recognizing the Scam
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.