Mortgage acceleration payoff programs – some caveats
Do NOT waste $3000 on the
Money Merge Account program from United First Financial to eliminate your mortgage in a few years. It is cumbersome, time consuming, and limited. All their hype about algorithms and such with the juggling of at least 2 accounts is easier achieved with chunk payments. [This company has changed their name to “Worth Unlimited” – same players, same game. Mahalo to Joe Taxpayer for alerting me to this on his excellent site: JoeTaxpayer.com.]
A recent online class I took taught the basics of early mortgage payoffs with a HELOC or any other interest bearing line of credit. This ingenuous method was the brainchild of a couple of Australian women who wanted to beat the system of the 30 year mortgage.
Take a $500,000 30 year mortgage at 5% (this will be what I will use as the example). The monthly payment for principal and interest (P&I) is $2684.11. Property taxes and insurance (T&I) are usually added on to this, but I will not add those in for this example, but be aware that these are additional payments required. I will also round out the numbers to make it easier to understand from this point on.
With the very first mortgage payment of $2684 (P&I only), $2083 is interest, $601 is toward principal. The loan is reduced by $601 for a new balance of $499,399. The next mortgage payment of $2684 is broken down to $2081 towards interest, $603 toward principal, for a new balance of $498,796. The next mortgage payment of $2684 has $2078 going towards interest, $606 towards principal. This continues on with the bulk of the monthly payment going towards interest, until year 16 (!) when more of the payment starts going toward the principal because the balance of the loan is lowered enough for that to happen, and your loan principal starts getting paid off faster and faster. If you make regular steady payments of $2684 every month for 30 years, you will have paid in almost double the amount of the initial loan!
The Australian ladies discovered this “secret”.
Use $10,000 from a line of credit, like a HELOC, to pay towards principal (make sure you specify that to the bank when making the payment). This will reduce the loan balance by $10,000 to $490,000. This automatically will “step” you up to month 16 of scheduled payments, and you would have saved over $32,000 of interest, because of the way the amortized 30 year payments are scheduled (16 months x ~$2000/mo interest = $32,000).
You will still have to pay off the $10,000 HELOC advance – but even if that is at an interest rate of 10%, and you pay it off in a year, your “cost” is $11,000, but you saved $32,000. Your actual cost is only the 10% interest ($1000) but you are taking out a loan that has to be repaid, so I include the sum in this calculation. Even so, the savings are big time!
If you can do this 18 years in a row, your mortgage will be paid off in full, 12 years ahead of time, and you will have saved $214,000 in interest. The sweet spot seems to be in the 9th year, when the mortgage payments begin to weigh more on the principal than the interest. For $90,000 of pre payments (9 years x $10,000), you save $178,000 in interest.
For this to work, you will need enough income to pay down the $10,000 HELOC every year.
Compare this to: if you did nothing but pay your regular mortgage monthly payments for 30 years without any additional principal payments, you will end up paying $466,000 in interest for your $500,000 loan.
Another way to battle this 30 year mortgage debt is to pay $1000 more per month towards principal reduction. This works out almost the same as a $10,000 principal reduction payment once a year.
You can “play”with the numbers using Joe Taxpayer’s spreadsheet (click on green “My MMA spreadsheet”, then open the xls document) which allows you to change the terms and amounts of the loan, as well as adjust any payments. You can then see the interest savings as well as the principal balance remaining for whatever scenario you chose to adopt.
In general, it seems that the more you can put toward principal at the beginning of the loan, the greater the savings on interest. Which has me thinking of a new strategy the next time I borrow on our home. Instead of going for the highest loan value at the fixed 30 year rate, I might be better off getting a lesser loan, and getting a higher HELOC.
The advantage of a 30 year mortgage is the fixed rate and the length of time the loan is available. However, the monthly payment does not change, whether you owe $500,000 on the loan or $50,000 on the loan. Fees and points are added into the loan which can easily top $10,000 of additional cost from the get go.
The advantage of a HELOC or interest only loan is that you use it if you want or need to, and the monthly payment decreases (or increases) as your balance changes, and these are usually loans without fees or points. The disadvantage is that the interest rate fluctuates and the loan usually expires in 10 years. HELOCs can also be closed at anytime at the bank’s discretion.
Currently, interest rates are very low – 5% or a little less for a 30 year conventional mortgage. These methods of paying down one’s mortgage faster makes sense, and it makes even more sense and has more interest saving advantages when the loan is at higher interest rates.
Although I would love to have a home debt free, it is also a waste of potential for me. Sitting on a house with 100% equity is like sitting on a pile of gold. It is great to have, but it is just what it is. This is Suzie Orman’s ideal retirement model – owning your home debt free. This does not, however, mean expense free. You can still lose your home due to catastrophic medical or unforeseen expenses, to lawsuits, fraud, and your own intended heirs getting greedy.
I would rather use as much of the equity that I can in order to acquire more cash flowing assets such as rental property. Good rental property. These cash flowing assets can be the income used to pay the mortgage payments on our financed home. Sweet chickens!
Additional income from your investments can pay down mortgages on the properties. This is good debt being paid off with cash flow that is forever.
Susie Orman’s message of eliminating all debt can backfire and leave you looking like a target with limited options. Learn the difference between good debt (used to acquire assets that put money in your pocket) and bad debt (doodads, toys, trips, jewelry, clothes, etc.). Avoid and eliminate bad debt, use good debt to get rich.
Aunty just found a really good article over at the FinancialMentor.com about the pros and cons of paying off your mortgage or investing. Really a good read. Turns out he is a fence sitter, but he has a solid fence in place.