Biweekly conversion

The idea is that many people are paid biweekly, and therefore you can afford to make 13 mortgage payments per year rather than 12. If you were to make 13 mortgage payments, your mortgage would be paid off more quickly. Using PC loan, I set up a $100,000 30-year fixed-rate mortgage at 9 percent. The monthly payment is $804.62. Taking this and multiplying by 13/12 gives $871.67. Making payments of this size simulates a biweekly mortgage. So I set up an "alternate loan" with a payment of $871.67 and solved for the new loan term, which turns out to be 264 months (22 years).

You can achieve this earlier payoff yourself by paying additional principal on your mortgage whenever you receive three biweekly paychecks between mortgage payments. During the two months that this occurs, send in an extra half mortgage payment, and have it applied to your mortgage principal.

I can think of three reasons not to use a third party to arrange this for you:

1. The benefits are overstated. The benefits often are stated, even by respected consumer journalists, as the amount of interest expense that you avoid by paying off your loan early. Implicitly, this assumes that the reinvestment rate on you money is 0. (This is tantamount to assuming that had you not made the thirteenth payment on your mortgage you would have burned the money instead.)

   You can use PC-Loan to see how this assumption gives misleading results. Change the reinvestment rate to 0 (you do this under the Options menu under "setup primary loan"). Then compare the regular loan with the simulated biweekly "alternate" described above. After 360 months, the simulated biweekly saves almost $60,000. However, if you change to a more realistic reinvestment rate of 6 percent, the savings are only $6658. The savings go away completely if you assume a reinvestment rate of 9 percent. Incidentally, the effect of the reinvestment rate on the value of shortening your mortgage term is at the heart of the flame war over 30-year vs. 15-year mortgages.

2. The costs are understated. When a third party sets up a biweekly payment schedule, they disclose their upfront fee. What they typically do not make clear is the fact that they gain the use of your money (this is called "float") between the time they take your payment and the time they make the mortgage payment. For example, if you are paid on the 10th and the 24th of the month, and your mortgage payment is made on the 1st, they have half of your mortgage payment for 20 days (from the 10th to the 30th) and the other half for 6 days (from the 24th to the 30th). This could cost you $100 or more per year in interest you otherwise would have earned by having the money in your own account.

   April 1997 update. I received an email from someone who signed up for a biweekly conversion, and the "float" loss was even worse than I described. The conversion company keeps some of your money until the end of the year, and then makes an extra payment on the mortgage. This consumer was very outraged and canceled his participation, even though he very much wants to pay off his mortgage early. His email said

   you are absolutely right in printing your article

3. You inject risk into your mortgage. This is the most important reason not to use a third party to set up a biweekly mortgage plan for you. What guarantee do you have that the money that you send in actually will be used to pay your mortgage? The third party could decide intentionally to abscond with the money. Alternatively, they may start out with good intentions, but if they need cash they may "temporarily" borrow some of the money from your account, and then gradually slip into the habit of borrowing more money more often, until they reach the point that they cannot make your mortgage payments.

Amateur Mortgage Pools

I call these amateur mortgage pools, to distinguish them from the mortgage-backed securities created by GNMA, FNMA, FHLMC, and various private conduits that sell through investment bankers. The agencies and conduits that issue these securities design the securities in such a way as to insure that you receive the principal on the mortgages. They set aside reserves for losses when individual mortgages default, and they aborb these losses so that you do not feel them.

With amateur mortgage pools, the chances are you are not protected against losses. Moreover, they tend to buy the worst mortgage loans available--the loans that the professionals will not touch. Incidentally, in today's market, the professionals are buying much riskier loans than they would have several years ago. This means that the amateurs are left with real "toxic waste" in which to invest.

After an amateur pool has been in existence for two years or so, the defaults start to cut into the ability of the pool to make payments. That is when the stories come out about people losing their life savings in the pool. Don't let it happen to you. Stay away from amateur mortgage investing.

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