No fee needed for extra principal payments
By Greg McBride, CFA • Bankrate.com

You open your mailbox and find a letter from your mortgage lender or loan servicer spelling out a way to save thousands in interest on your current loan, and they're not pitching a refinance.

"What is this?" you ask yourself. With a quick glance over the enclosed paperwork, you deduce that whatever it is must certainly be worth the initial sign-up fee and ongoing monthly service fee that is charged. Reading closer you'll find that a biweekly mortgage payment plan is being proposed.

A biweekly mortgage payment plan involves making half of your regular monthly payment every two weeks. Thus you can make 26 half-payments, the equivalent of one extra mortgage payment every year. Between the extra payment and the consistent biweekly payment schedule, the interest savings accumulates as the loan balance declines.

But this isn't worth paying any kind of fee -- unless you are the type to pass up a perfectly good water fountain in favor of a vending machine selling bottled water.

You can accomplish the very same objective on your own with greater flexibility and without coughing up any fees whatsoever. The only requirement is that your loan permits additional principal-only payments. Preserving the flexibility to make extra payments on a schedule suited to you is not to be taken lightly. You decide when and how much extra to pay. Meanwhile, you have the option to refrain from additional payments in those lean months.

What about locking yourself into a payment every two weeks? A biweekly schedule is just grand, as long as you are paid biweekly. But consider what happens if you change jobs and are suddenly paid on a bimonthly, or monthly, basis.

Adhering to a similar schedule on your own is a little different, as loan servicers typically will not accept partial payments, regardless of whether they are made on a biweekly basis. Instead, borrowers can include an additional one-twelfth mortgage payment each month to be applied to the principal, or make an extra principal-only payment once each year. Either way, the borrower maintains control over whether to continue, or discontinue, the routine of paying down the principal.

Lenders will often try to sell the advantages of going through their biweekly plan, fees and all, usually trumpeting the notion that most people don't have the discipline to consistently pay down their mortgages. This may be true, as discipline is certainly a key factor if you aim to do this on your own.

But those possessing the discipline to diligently work toward building wealth may ask themselves if accelerating the repayment of principal is the best return on investment. While the answer varies depending upon individual circumstances, with mortgage rates as low as they are, it likely is not. To a borrower in a marginal tax bracket of 27 percent, a mortgage rate of 6 percent only costs 4.38 percent on an after-tax basis, provided the borrower is deducting the interest from his or her taxes. A disciplined investor could well look at this and decide to devote excess cash flow to other investments with better return prospects than prepaying a mortgage.

While the benefit trails the potential of higher risk, higher return investments, not everyone has the stomach for risky investments. The after-tax return of prepaying a mortgage still exceeds that of other risk-free alternatives, such as money markets, certificates of deposit or Treasury securities. However, much of that is a liquidity premium, as you can't withdraw home equity without borrowing. In that sense, the cash that goes toward building additional equity instead of interest is a stranded asset that the borrower cannot fully realize until either the home is sold or the loan is paid off ahead of schedule, eliminating further payments.

But by maintaining control over when and how much to prepay, the borrower can reap an equal or greater reward -- without paying a fee for the privilege.

Greg McBride is a financial analyst for Bankrate.com.

For advice regarding your specific situation, please e-mail one of Bankrate.com's Q&A experts or visit the Personal Finance Advice channel on Bankrate.com.