Smoke and Mirrors
/OK, I’m going to apologize on the front end as this will be a little longer read than my typical update. But I’m pretty passionate about the topic, so forgive me. I’m over all of the gimmicks out there designed to pay off your mortgage faster. Honestly, I think it is the wrong argument anyway, or at least wrong from an execution standpoint, and I’ll get to that shortly. The two I’m going to pick on today are the bi-weekly mortgage and the concept of using a HELOC in place of a mortgage as strategies for paying off a mortgage faster.
I’ll start by focusing on the whole concept of what is really required to get a mortgage paid off quickly. It’s not rocket science. If you want to pay a loan off faster, and it doesn’t really matter what type of loan it is, you simply pay more than what is required. There is no magical formula that makes the debt disappear. It requires discipline and effort. You want to lose weight? Eat less calories and get on a treadmill. You want to save money? Do a budget and manage your finances by it. Want to be a better golfer? Go to the driving range. You get my point… The bottom line is that to accomplish anything out of the ordinary, your behavior has to be out of the ordinary. It’s all about discipline.
A bi-weekly payment plan will definitely help you pay a loan off faster. You are simply making 26 half payments every year – in essence, one extra principal payment per year. I don’t have a problem with these plans unless there is a fee involved. The reality is that you can make that extra payment on your own – either portioned out monthly or annually, and accomplish the same thing with no extra cost. So why pay a fee (most of the bi-weekly programs out there charge one) to do what you can do by yourself? It’s all about discipline.
Recently I had a client decide he would buy his home using a HELOC to finance it versus a traditional mortgage. He was wooed by a company’s claim that by using its strategy, he could pay his home off in 7-8 years using a HELOC versus the traditional mortgage. This concept intrigued me enough to get the book, offered by the company promoting the strategy, and read it. I was open minded about it hoping to learn something when my natural skepticism hinted that I wouldn’t. I guess I should have been immediately more skeptical when glancing through the 127 page book, I noticed the last 56 pages were about strategies to make more money and credit repair. I read it anyway – and was once again confirmed by the fact that if you make anything sound too good to be true, not only is it, but sadly there are those out there that will believe it – and ultimately buy it. At the end of the day, the concept is nothing more than paying a loan off faster by paying more than is required monthly. Granted, I believe that a HELOC is a great product and can be used strategically to both grow and protect wealth. I have one myself. But the central argument used in the book is that it is all about debt balance and not rate. I couldn’t disagree more. Banks make money based on the rate. You eliminate balance by paying principal. They faster you pay principal, the less interest (rate) you pay – that’s the whole point, to pay less interest. You can definitely get your loan paid off faster using this strategy, but it is just another gimmick. You are simply paying more than what is required versus a traditional mortgage. There is actually a real danger here and that is you are using an inferior product (a loan with a rate that fluctuates) to accomplish what can be done on your own – paying extra on the debt. And I’m sure there is probably a pretty good sized fee from the company touting the strategy to help you get everything set up.
But are we really even focusing on what is in my opinion the more important concept? I agree that it is all about getting out of debt. But what does that really mean? Most would say that it means owing no money to anyone. I disagree. I’ve stated for years that being debt free isn’t really about having no debt – it’s about having the ability to pay off the debt anytime you want to. In other words, it’s about having more financial resources than money owed. If you have $200,000 in a safe investment and owe $150,000 on your mortgage, you have the ability to pay that loan off anytime you want – you are debt free, you just choose strategically to have debt. I used to crack up listening to The Money Game back in the early 90’s with Dave Ramsey and Roy Matlock. They used to argue about this concept. Back then mortgage rates were around 8% and the rate of return on equity investments was around 12%. Dave wanted people to pay off their mortgage and Roy argued that it made more sense to invest the money versus paying off the mortgage – an alternative to the traditional thought of being “debt free”. I love Dave, but I was always on Roy’s side when they argued this topic.
I’ll give you a simple example related to the whole HELOC versus mortgage concept – and I’ll be generous to the HELOC concept assuming that the rate never changes. The last two times the Fed started increasing the Fed Fund rate (that prime is tied to), prime topped out around 8%. Prime is currently 4.25%, so we’ll use that figure. The 30 yr mortgage is at 3.75% right now, so we’ll use that figure as well. We’ll assume a $200,000 mortgage and that the payoff target is 8 years. The P&I payment on the mortgage is $923 per month. We’ll assume an average of $4,250 per year of interest on the HELOC (that is averaging the interest over 8 years with constant rate assuming the balance will be paid down to zero by the end of 8 years). To pay off the loan on a monthly basis would require a payment of $2,392 ($2,038 in principal dividing $200,000 by 96 (8 years) plus $354 in average interest). So the first 8 years will require an additional payment of $1,469 versus the 30 yr mortgage. If the person with the mortgage invests that extra $1,469 over the 8 year period at 6% (very conservative as pretty much any 10 year period in the history of the equity markets provides a return of 8%+), the total saved/earned will be $181,337. By the way, his principal balance at this point is ~$163,000, so he’d have the cash needed to pay off the balance if he wanted to at that point – with some left over. But here is where the real magic exists. Let’s say that the person that did the HELOC and paid his loan off in 8 years now invests the $923 per month (the amount the mortgage guy will still be paying) over the next 22 years. His investment will grow to $506,687. Let’s assume that the guy with the mortgage, who invested his money over the first 8 years, continues to pay his mortgage and never pays an extra penny towards his investment or paying his mortgage early (I’m keeping the amount paid by each the exact same for the full 30 years). The investment he grew over the first 8 years will be worth $653,454 by the end of the 22nd year. He comes out $150,000 ahead. So who was the real winner? And all of this assumes the HELOC rate never changed, the investment return was below average, and isn’t considering the tax benefit of the interest paid. Thank you compound interest – the only real magic in this entire equation.
So I guess my point is that regardless of strategy, and I believe I’ve proven that investing versus paying down the mortgage (particularly in this low rate environment) makes more sense, what doesn’t make sense is to use gimmicky options, especially if there is any type of fee involved, to pay the mortgage off early. If you want to do that, get a safer fixed rate option and just pay extra. Or, in my opinion, invest the difference and work towards having the cash available to pay the loan off when you want to. Either way, it’s all about discipline – not a hokey strategy.
We’ve seen a couple of dips since we started our run to better rates at the beginning of July. But the one we had last week took us out of the upward moving channel for the first time. It will be interesting to see if that continues over the days and weeks to come, but we’ll keep you posted.