Many of us purchase our homes, our cars, or our education costs through the process of financing. We take out a 30 year fixed rate mortgage, 5 year car loan, etc. so that we will be able to own and use an asset without having to come up with all the upfront costs associated with it in cash. So we borrow and pay down the loan with both principal and interest for a number of years.
Interest rates and payments, especially in the low interest rate environment we are in now, often times do not seem like meaningful numbers because we tend to compartmentalize how we view the payments.
For example, let’s say you have a 5 year loan of $10,000 on your car and an annual interest rate of 2%. You look at what the monthly car payment will be and notice that you will be paying (on average over the course of the loan) about $9 per month in interest. Looking at that as a single line item makes it seem minimal. It’s a manageable cost that doesn’t upset me one bit.
But, when you look at it all together, collectively, to determine how much interest you will pay over the life of the loan, that number will creep up pretty quickly. In the previous car loan example, your interest that you paid over the course of the 5 year loan amounted to just over $500. That is 5% of the loan itself.
Debt doesn’t have to be viewed negatively though. Financing certain things, like purchasing a home, provides you with the opportunity to own a home that most would not be able to afford in cash. Instead of depleting all of your cash to purchase something, you have the ability to make monthly principal and interest payments over the term of the loan and can use your cash on your lifestyle or other income producing activities instead.
Especially with the interest rate environment we are currently in, one could make a pretty strong argument around using debt to leverage certain financial opportunities with the understanding that your money could earn more if invested elsewhere.
In other words, am I better off accelerating the payoff of my 3% fixed 30 Year mortgage or am I better off using that additional money to invest in the stock market or other business ventures that may have the opportunity to yield a greater return to me over time? That, my friends, is another great blog post topic so stay tuned for the numbers on that one!
But if there was some way for me to use debt to my advantage but meanwhile, also create a way to pay less interest over term of the loan. I would be leaning in to listen too. The not so secret, secret….
Paying down your long term debt in bi-weekly payments as opposed to monthly payments could shave years off your loan and reduce your overall interest payments by a significant amount. (For purposes of the rest of the post I will be using mortgage payments as an example, but the concept of biweekly payments and the benefit you receive could apply to all forms of debt that allows it).
Depending on the mortgage, you agree to pay a stated monthly payment that consists of principal and interest (unless its an interest only loan). This would consist of 12 monthly payments throughout the year.
However, with bi-weekly payments, you pay once every two weeks. There are 52 weeks in a year, so you would be paying 26 payments. By paying bi-weekly, you have created an opportunity to pay an additional months payment within the same calendar year. (Note: Bi-weekly does not mean twice per month. That would only amount to 24 payments throughout the year).
The logic behind paying bi-weekly is that increasing the frequency of your payments reduces the interest build up on a monthly basis and over the course of a 30- or 15-year mortgage that could mean a significant reduction in your payoff date.
Bi-weekly payments is also a forced savings and budgeting tool. Any time that you can automate a transfer to a retirement investment account or automate payments to pay down debt – you will benefit by not having to actively engage in the transfer or give yourself the opportunity to change your mind.
Automation in personal finance is one of the most efficient ways to create the habits you need to build wealth.
Depending on your mortgage, typically in the beginning years of a mortgage, your payments consist of more interest than principal pay off due to the fact that your loan amount is the highest it will ever be. Your interest you pay monthly is based off the previous months principal loan balance. So the more we can drive down the principal of your loan, the less interest you will have to pay. Bi-weekly payments accomplishes this without having to upfront a huge payoff!
By opting to pay bi-weekly mortgage payments as opposed to monthly, you saved approximately $34K of interest (that’s a 13% reduction) and you were able to pay off the loan 3 1/2 years early.
Remember to check with your mortgage provider to see whether or not they offer the bi-weekly payment option. Two things to confirm would be whether they will charge any fees to set up the bi-weekly payments or if there are any prepayment fees on your mortgage agreement.
The power that paying bi-weekly payments can have on your loan will depend on a variety of factors including your interest rate, term of loan, type of loan and whether or not fees will be charged as a result of the change.
But like anything as it relates to personal finance, it will definitely be worth looking into if you can manage the additional cash flow going out on an annual basis through the additional mortgage payment!
Hope you found this helpful!
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