“Recently, I heard an ad on the radio about a new type of mortgage from CMG Financial that allows you to use the mortgage as if it was a checking account. According to them, this allows you to pay off your loan in about half the time. Would you give me your opinion?”
Not a week goes by that a reader does not write me about some new early payoff scheme. They sprout like weeds because the soil is so rich. It consists of the millions of mortgage borrowers hoping that a good fairy will come along and show them how to get rid of their debt more quickly, and with less pain.
If I wrote about every one of these schemes, I would never have time to do anything else. This one was worth my time, however, because the central idea is attractive, even though its basic promise, to shorten the term drastically, is highly questionable. To get that result, borrowers must save a significant piece of their income every month and apply it to the balance, which they can do with any mortgage.
The basic idea, copied from a program developed by banks in the UK and Australia, is to allow the borrower to use his/her mortgage as if it were a checking account. The borrower’s paycheck, instead of being deposited into a checking account where it might earn interest of 1 percent-2 percent, is used to pay down the mortgage balance, thereby earning the much higher interest rate on the mortgage.
As the borrower spends money – for example, by writing checks, withdrawing cash from an ATM, or using a bill-pay service – the mortgage balance rises. Even if the balance at the end of the month is the same as at the beginning, the average balance is lower. Since interest accrues daily on the CMG mortgage, the total interest charged over the month is also lower.
The amount of interest savings depends on two things: the size of the borrower’s paycheck relative to the mortgage balance, and the portion of the paycheck that is saved. The second factor is crucial in generating large interest savings. If the borrower’s paycheck is $2,000, for example, and he/she saves 10 percent, then the deposit at the beginning of the month reduces the mortgage balance by $2,000, while spending during the month raises it by only $1,800, leaving $200 as a permanent reduction in the balance.
CMG has a simulation program on its Web site that allows users to calculate interest savings and term reduction but the program requires a savings rate of at least 10 percent. This makes it impossible to separate the benefit from being able to use the mortgage as a checking account from the benefit attributable to use of the borrower’s own savings to pay down the balance. Any borrower who uses 10 percent of his/her income every month to make an additional payment on a mortgage is going to shorten the term substantially – whether they are using the CMG program or any other program.
This is a critical issue because borrowers pay a premium price for the CMG mortgage. It is an adjustable-rate mortgage with a margin that CMG acknowledges is “higher than on other adjustable-rate loans.” (There is also an annual fee to defray the cost of providing transaction services, but a spokesperson for the company said it was only $40 a year).
Whether a borrower benefits from this program or not depends on whether the gain from using the mortgage as a checking account exceeds the cost of the above-market margin. There is no easy way to determine this. CMG does not allow users to calculate interest savings uncontaminated by extra payments, nor does it indicate how far above the market their margin is.
The CMG plan may discipline borrowers to save more than they would otherwise, which could be a valuable feature for some consumers. Forthright merchandising would stress this feature, rather than implying that the early payoff and mortgage interest savings that arise from the borrower’s own additional savings are due to the program.
Note also that CMG offers only one type of mortgage under this program. It is one of the riskier ARMs around because the rate is adjusted every month based on movements in Libor, a highly volatile index. This is not a mortgage for borrowers who would have trouble dealing with rising payments.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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