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Are biweekly mortgage payments a good idea?

Optimization
June 1, 2022

Biweekly payments squeeze in an extra payment each year because there are 26 two-week periods but only 12 months. Splitting a $2000 payment into $1000 and making it 26 times is $26,000 vs $24,000 on a monthly schedule. Biweekly payments are the most common mortgage acceleration program and save tens of thousands in mortgage interest. At a more psychological level, paying off a mortgage represents freedom, but is it a good financial strategy?

Let's evaluate four essential components of this financial strategy: cash flows, net wealth, opportunity cost/risk, and taxes.

First, making one additional monthly mortgage payment per year effectively trades short-term cash outflows for long terms cash inflows. You will pay ~$2,000 on a 30-year mortgage of $400,000 at 4.4%. Making an extra payment will end the mortgage 4yrs & 3 months earlier. Excess cash outflows will amount to ~$52,000 ($2,000 x 26yrs)  and in return increase net cash by $2,000 per month on the remaining loan term i.e. $102,000 (over 51 months). $50,000 ($102k-$52k) is a great nominal return of 96%! However, we're missing the time value of money. Discounting those cash outflows and inflows to the present provides a rate of return equal to your mortgage interest rate. For those less familiar with NPV calculations, the rate of return is lower than first glance, but not bad when interest rates have inched past 5%.

Second, paying extra money towards your mortgage goes 100% towards the principal and compounds over time. For example, in year 10 you would have paid off 26% of the original principal balance with biweekly payments vs 20% in standard monthly payments. A 6% difference in principal is $24,000 and greater than the $20,000 in extra payments made. That additional $4000 may seem like magic and occurs because mortgages are based on simple interest payments due each month. Deviation from the standard plan compounds equity in your favor. Just like investing returns compound over time, so does paying off your mortgage over a shorter term. Net wealth is assets minus liabilities, paying down liabilities is half of the equation!

Third, a knee-jerk criticism of paying your mortgage faster is opportunity cost! Am I not better of putting my money in the stock market that on average returns 8%? The answer isn't a simple yes because the stock market comes with volatility and the 8% return isn't free of risk. Whereas, the rate of return on making biweekly payments is risk-free and carries no pre-payment penalty (in most cases). One of the core themes of portfolio construction is diversification, which typically means adding bonds as risk appetite decreases. Mortgages are similar to bonds in some regard. Adding money to your mortgage isn't a binary decision but rather one of portfolio allocation. Most homeowners would benefit by increasing their allocation of cash to home equity. Although, paying off higher interest credit card loans and maxing out retirement contributions in tax-advantaged accounts should come first.

Lastly, consider the impact on taxes. The mortgage interest deduction incentivizes homeownership by subsidizing the cost of borrowing. However, after the Tax Cuts and Jobs Act of 2017 the standard deduction was doubled to $25,900 (for a married couple filing jointly). Furthermore, state and local tax (SALT) deductions were also limited to $10,000. Assuming no other major deductions (like medical expenses and charity) homeowners now have to pay >$15,900 in mortgage interest to "itemize" and receive any tax benefits of mortgage interest.  The tax policy is progressive towards renters who get a larger standard deduction but reduces the amount and duration of mortgage interest tax deduction for all homeowners and eliminates it for many. When tax policies change, so should your behavior. Minimizing mortgage interest, compounding equity, reducing portfolio risk and tax efficiency are all compelling reasons to consider paying off your home loan faster. Biweekly payments align well bi-weekly paychecks. Stay tuned for more dynamic strategies that change with interest rates and earning power to optimize mortgage payments.

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