A co-worker heard on the radio that there is some kind of program that will pay off your mortgage in 9 years, legally, but it costs a few hundred dollars in fees. He was thinking of enrolling. I told him that using mathematics, having a basic understanding of finance, and a few simple "tricks" can accomplish the same results for free.
I'm not sure exactly how this particular "9 year payoff" program works, but I'll give you some broad strokes about how I would set up a similar program and bilk the unwitting homeowner. I also want to mention up-front that even though the math shows that these tricks work, you can still get burned. I'll give examples later. Lastly, I've read Dave Ramsey's stuff and I HIGHLY doubt he would approve of some of these tricks. I like Dave Ramsey and generally agree with his advice, but on a couple of things, like the simple finance tricks I'll show you, I really disagree with his advice.
Caveat emptor.
The Basic Idea Behind Paying Off Your Mortgage Sooner
In one sentence, these programs work by having you use a second mortgage to PAY OFF your first mortgage. This will save you lots of interest payments. Some critics think this is just shifting money from one debtor to another. It is, but it works. And if you are still paying PMI then this makes even more sense. But first you have to understand some basic finance. Note in the first sentence that I said "PAY OFF" and not "PAY DOWN". If you are not paying off the entire mortgage with your second mortgage, then what I'm going to show you is foolhardy.
Basic Mortgage Concepts
These "pay off your mortgage fast" programs are popular right now because interest rates are EXTREMELY low. If rates go up the popularity of these plans will go down. Why?
If you have a second mortgage (commonly called a home equity loan or line of credit...I'll assume a HELOC [home equity line of credit] is your "second mortgage" for the rest of this blog) odds are the interest rate is MUCH lower than your primary mortgage. If yours isn't, now is the time to remedy that situation by refinancing. These programs will only work if your HELOC rate is lower than your primary mortgage's rate. Most HELOCs have a variable interest rate. Even so, it's likely your rate is capped at some percentage. Some HELOCs have a "fixed rate partition" as well, meaning you pay a fee or a bit higher interest rate for the peace of mind that your rate is fixed regardless of the future of interest rates. These programs really only work if you have a fixed or variable rate that can be capped at a rate below your mortgage's. If not, be VERY careful before you move foreward.
How Mortgages Work
Assume you borrow $200,000 for 30 years with a 6% mortgage. You will pay $231,676 just in interest payments. If you have extra funds, never pay DOWN a mortgage, only pay it OFF. I'll get to the reason later.
But, let's break that rule for this example. Given the mortgage example, let's say that after 6 months you inherit $5000 and decide to pay DOWN your mortgage. That will actually erase almost $23,000 from the interest over the remaining 29.5 years. Perhaps you could do better in the stock market, but that's a nice 450% return, albeit over 29 years. That's 16% on an annualized basis. Guaranteed money. It's likely that most people would take a guaranteed 16% return over 29 years vs any other investment out there.
But it gets better. Instead of inheriting the $5000, let's say you take it from your HELOC. If the HELOC has a lower rate, you are saving money. Let's say every year in January you take $5,000 from your HELOC and make an extra principle payment to your mortgage, then pay off that entire $5000 by the next January. If you do that over 30 years you ultimately pay off your mortgage in about 15 years, saving about $120,000 in interest. But trust me, you actually DO NOT want to do this...more on why this is soon.
Amortization vs Simple Interest
Here's the reason why this trick does work...HELOCs are "simple interest" loans whereas your mortgage is an amortized loan.
An amortized loan has payments that are made on a periodic basis (generally monthly) and interest is calculated on a monthly basis. A simple interest loan also has payments made on a periodic basis (generally monthly) but the interest is calculated on the average daily balance. A mortgage usually also allows for a grace period for the receipt of payment without penalty. Generally if a mortgage is due on the 1st you really have until the 15th to pay. A simple interest loan generally has no late penalty, the interest simply keeps accruing daily. Therefore, if you have a 15 day grace period on your mortgage, you really shouldn't pay your mortgage until the 15th. I NEVER pay my mortgage until the 15th. And utilizing the grace period does NOT negatively affect your credit rating.
A home mortgage uses amortization to define payments. This is very different from a simple interest loan, such as a car loan...or a HELOC. Assume your mortgage payment is due on the first of the month. If you pay it 10 days early every month you will NOT pay it off sooner (actually you will, the last payment will be 10 days early, hence the loan is paid off 10 days early).
A simple interest auto loan or HELOC is different. If you can make your payment even ONE day sooner every month you will actually pay off your loan sooner. At a minimum your PAYOFF AMOUNT for the last month should be significantly less.
One More Quick Helpful Hint
If you have direct deposit into your checking account from your employer and you have a HELOC, why not just have your direct deposit go right into your HELOC account? Not all banks will do this. Mine does. I freely admit to everyone that I live paycheck-to-paycheck. I leave no extra cash-cushion in my checking account. Checking accounts pay no (or very little) interest. If you live paycheck-to-paycheck then you know that the first few days after you get paid you have tons of money in your account, but that balance slowly reaches zero by the next paycheck. You can save a lot of interest having that money work for you by reducing your HELOC's average daily balance. I like having my money work for me with no extra risk.
Basic Finance
It's a basic axiom of investing that, all things being equal, a guaranteed return of 5% is better than a guaranteed return of 4%. In the real world all things are not equal. One person may pay a 4% mortgage rate vs his neighbor paying 5% for various reasons. But it all comes down to risk. The reason you are paying any interest is because the mortgagor is assuming some risk that you may default. So, it's probably common sense that if you had $100 to invest you'd rather make 5% than 4%, all other things being equal. But it's also likely that the higher-yielding investment has a little more risk too.
People struggle with the fact that costs work the same way. If I can invest at a guaranteed 5%, but my mortgage is 6%, it should be obvious that paying DOWN my mortgage should occur before I invest. But that is actually wrong, like I said earlier. I'll get to that soon, trust me
Why Use Your HELOC to Pay Off Your Mortgage?
If your mortgage is 5% and your HELOC is 4% and you have enough HELOC funds available, then you should PAY OFF your mortgage using your HELOC. The whole trick is that you move whatever funds you have available from lower-yielding investments to higher-yielding investments. This is how these "pay off your mortgage in x years" plans work. Now you know.
Pitfalls and Caveats
Pitfall Number One - Never Pay DOWN a Mortgage, Only Pay it OFF
Now we are finally getting to the controversial stuff.
Never pay DOWN a mortgage. Only pay it OFF. The exception is if you pay PMI. An interest rate can be thought of as a risk premium you pay the bank in the event you default. By paying DOWN a loan you are still paying the bank the same rate, but now you are assuming more of the default risk. You are giving the bank a free ride.
But you are probably thinking about the example above where I paid off my mortgage in half the time by using $5000 annually from my HELOC. Well, that does work mathematically...you are getting a great return, but you are taking on MUCH MORE risk.
Think of it this way. Property values can go down. By paying extra principle, but not all principle, the bank gets more liquid cash and less of a depreciating asset. This is the key point that most people forgot about during the real estate boom of the 2000's. You may even be reading this right now saying that I'm wrong, that the value of YOUR house will never go down. You'll never lose your job and risk foreclosure. Read on.
When the housing market tanked in the US in 2007-2009 banks could only foreclose on some "underwater" houses, but not all. Why? Something called loan-loss reserves (think of it as "bad debt contingencies") that banks needed to maintain. If a loan is not "performing" then the bank must have more cash-on-hand to cover the default. This is a legal issue for the banks, it helps to deter "bank runs" where people remove their cash from the banks because the bank is (or appears to be) insolvent. The easiest way for a bank to become insolvent is to have too many non-performing loans.
If more houses are in forebearance then more loan-loss reserves are needed for legal purposes. So the banks did a lot of borderline-illegal things to keep loans from looking "bad" on their books. Many families were allowed to live in their homes for years without paying a nickel on their mortgage because the banks COULD NOT foreclose on them due to the increase loan-loss reserves that would be needed. That's right, people lived in their homes without paying their mortgages. Others did "strategic defaults" and "short-sales" to further improve their position with their bank. (You can google all of this on your own.)
Now think about it for a second...if there are 2 homes that need to be foreclosed on, but the bank can only foreclose on one of them, will it foreclose on the family with the higher or lower "loan-to-value" (ie, how much equity is in the home)? The bank will always foreclose on the home with more homeowner equity. The bank can wring more value from it with less of a hit to their reserves. This means that homeowners who practice paying DOWN their first mortgage early have increased their risk of foreclosure if the economy or housing market tanks again. So again, assume two mortgages are in forebearance. One has a single payment left on it after 30 years. The other has 20 years of payments remaining. Which will be the candidate for foreclosure? That's right, the mortgage with one remaining payment.
Remember, even if you only have a single payment left on your mortgage, and you don't pay it, the bank gets your house and all of your equity and you get nothing. So, by PAYING DOWN your mortgage you are helping the bank eliminate their risk.
There is an old saying in finance..."If I owe a hundred dollars to the bank and can't pay, I have a problem. If I owe a million dollars and can't pay, THE BANK has a problem."
More Pitfalls to This System
- None of this will work if you have prepayment penalty clauses in your mortgage. I've never seen a conventional mortgage have this, but I know that some of these mortgage brokers can con people into better terms by sneaking in these clauses. Do some research first.
- If your variable rate goes higher than your mortgage rate you have a problem. Watch for signs that interest rates are rising. I don't anticipate rates going higher for at least a few more years. You can always refi later if they do. Consider a HELOC with a "fixed rate" option if possible. There are risks using this method. There are always increased risks with increased returns.
- Dave Ramsey would say that you don't get the motivation and the psychological win of paying off a debtor completely when you follow this kind of system. Bunk! If you need motivation, keep a spreadsheet of all of the interest you are NOT paying to some bank. Remember that you should always pay off anything with a higher rate/higher balance/and longer term than any other debt. That's simple math. Worry about winning the war, not some small battle.
- All first mortgage interest is income tax deductible in the US. Only the first $100,000 of second mortgage/HELOC interest is tax deductible. Tax considerations also affect returns.
- If your credit is terrible then removing a creditor from your report (ie paying off your HELOC first) might be a better idea. It depends on your situation.
- I use my HELOC as my "emergency fund." It's where I get my liquid cash in a pinch and pay only a small amount of interest. If you do too then note that you'll need another source for your "emergency fund". Again, the Dave Ramseys of the world will tell you not to use a HELOC this way. I'll again ask you whether it is smart of have an "emergency fund" in a savings account earning 0.10% interest, or working for you eliminating HELOC interest.
- Don't liquidate your savings or investments to pay DOWN your mortgage. Odds are you will earn more money investing the cash. That's why these tricks use a HELOC...you aren't using the money anyway, might as well use it to pay off something with a higher interest rate. But using that concept you could also invest in stocks (or anything else) as long as your return is greater than your HELOC rate and the interest savings from PAYING OFF your mortgage. This is very dangerous to do since stocks can go down. I've done this in the past with stunning results. You can too. All you do is find a stock with a dividend yield higher than your HELOC. Then determine how much it would cost (google is your friend) to buy an at-the-money, one year put option on your stock. If the cost of the put and the HELOC's rate are less than the dividend yield, you have a riskless return on your investment. There are lots of stocks where this can be done.
But that's another writeup. Bottom line...your HELOC and home equity should be viewed as a source of funds that can be used as a tool to help you in your financial goals.