When weighing mortgage options, most Canadians are obsessed by the rate they are being offered. News Flash: Given a choice of two rates, a lower and higher one, it is possible that your mortgage ends up costing you more (sometimes much more!) – even though you might have a comparatively lower rate! Find out how
Frequently Overlooked
So, you don’t think that anything else, other than interest rates, can truly reduce the overall cost of your mortgage? Well, think again!
Depending on many factors such how your mortgage is structured, the length of the amortization period and the repayment privileges you are offered, amongst others, the total cost of two mortgages of the same value could be vastly different. But the single most important feature that could weigh on your mortgage is the pay frequency – an item that’s frequently overlooked by Canadians.
While the mortgage Term (3-years, 5-years etc.) dictates how much your mortgage will theoretically cost you, it is your Pay Frequency which directly determines how much you end up paying for the mortgage. That’s because the Term outlines for how long the lender is committed to lending you the money at the agreed rate of interest; but your Pay Frequency determines how long you choose to make use of that loan at the agreed upon rate.
If you repay the money faster than the Term, then you’ll obviously pay less interest on the money borrowed. It’s really that simple! And the mortgage feature that determines how quickly you can pay back your loan is the Pay Frequency.
But before we demonstrate HOW pay frequency can lower (or increase) the total cost over the life of your mortgage, lets explain WHAT it is. Typically, there are 6 major variations of pay frequency, with others (like Annually) less commonly used:
- Monthly: This frequency is the most common amongst most mortgage holders. Most often, lenders will tap into your checking/savings account on the first of each month and charge you your monthly mortgage installment.
- Semi-Monthly: Instead of making a single monthly payment (of say, $1,500), you make two equal payments of $750 each, typically on the 1st and the 15th of each month. Since you are still paying $1,500 ($750 x 2) a month, you don’t same much (compared to Monthly)
- Bi-Weekly: This may seem eerily similar to semi-monthly – but it is not. Bi-weekly payments are calculated by using the monthly payment ($1,500) and multiplying it by 12 ($18,000). This result is then divided by 26 ($692.31), resulting in slightly more than half of your monthly payments (towards the principal) are made earlier (than monthly), which results in a minuscule saving over the life of your mortgage
- Accelerated Bi-Weekly: Here’s where you start realizing some savings. Like in the case of Semi-Monthly, your monthly payments are halved ($1,500/2 = $500). But those payments are taken out in exactly 14-day intervals. The way this math works out, at least two times a year you’ll be making three payments. Over a 12-month period, you’ll have made 13 (instead of 12) payments, thereby reducing your principal balance more so than in either of the three previous pay frequencies.
- Weekly: When calculating your payments under this type of pay frequency, the monthly ($1,500) payment is multiplied by 12 ($18,000), and then divided by 52 ($346.15) – to represent the number of weeks in a typical year. Since 3/4th of your payments are made before the end of the month, this pay frequency nets you a marginal amount of cost-savings (compared to monthly) – but not much
- Accelerated Weekly: In this pay frequency, your monthly ($1,500) payments are divided by 4 ($375) and are taken out of your account at exactly 7-day intervals. The math works out in your favour because a) you end up making a few extra payments each year; and b) the weekly ($375) payments are slightly higher than those made in a regular weekly ($346.15) pay frequency. This results in your discharging your mortgage much faster
While frequently overlooked therefore, as we can see, your pay frequency definitely impacts the amount of money you pay to own your home, and the length of time it takes you to pay off your mortgage. In general, regardless of what the interest rate is, the longer you own money to your mortgage company, the more interest you’ll par.
Frequency Math
Pay frequency math determines three very important elements of mortgage payments:
- The number of regular installment payments you make each year
- The number of “extra” payments a particular pay frequency can provide
- …and the amount of each installment
So, why does all of this matter, and how does it reflect on your pay frequency?
It’s because those installments are composed of a composite of interest and principal repayments. While interest doesn’t do anything to reduce your costs, it’s the reduction in your principal that actually helps you save money. How can pay frequency help you save cost?
The more frequently you reduce the principal amount outstanding, for instance by opting for Accelerated weekly instead of Bi-weekly payments, the less balance there will be outstanding upon which interest is calculated. Therefore, the quicker your loan principle starts decreasing, the less total interest you’ll pay for the entire loan.
Let’s take a closer look at the math as explained in the previous section, using our online mortgage calculator.
For the purpose of this exercise, we’re assuming a simple mortgage of $100,000, with an interest rate of 5%, amortized over 25 years. As explained in the prior section, the numbers presented in the table above clearly also demonstrate the impact of your pay period on the total cost of your mortgage. The total amount repaid over the life of the mortgage gradually declines (from left to right) depending on the type of pay frequency you choose.
As a general rule of math, the more recurrent your pay frequency is, the faster your mortgage will be discharged, and the less total interest you’ll pay. Your total amount repaid will consequently be reduced as well. And though it may seem counter intuitive at first, repaying smaller installments (like $129.80) every 7-days (Accelerated weekly) can lead to cost savings compared to making larger ($584.59), albeit less frequent (monthly) payments.
