A financial planner once told me that people did not really concentrate on saving for retirement until they paid off their home mortgage. The reason was that discretionary income was so precious after all mandatory monthly obligations were satisfied that consumers spent what little was left on a wanted treasure, trip, or recommended stock or bond.
As we mentioned in a recent column, solicitations for biweekly payment plans have become more common as borrowers look to counter the recent “foreclosure” buzz by taking a shot at paying off their homes faster. Instead of the standard one-payment-per-month schedule, some companies specializing in accelerated-payoff programs solicit mortgage brokers with a custom option for their loan customers. For example, for a one-time fee of $395, the borrower can have a tailor-made plan written for his or her loan. The mortgage broker is offered an incentive, typically $300, to “sell” the program to his or her customers.
There are several options and alternatives to loan-acceleration programs. One of the more sophisticated is an Australian-based concept that calls for running all financial transactions (checking, savings, money-market accounts) through a line of credit that would be the first lien on your house. (In many countries such as Australia and Canada, mortgage interest is not tax-deductible.) Instead of paying on a conventional first mortgage, your mortgage would be a first line of credit. You would deposit your paycheck directly into this account each month and then write checks for all your needs (groceries, dentist bill, utilities) from this account.
In a nutshell, the loan’s philosophy is that since the interest paid “out” to your mortgage is greater than the interest paid “in” to your checking or savings account, it’s better to pay the mortgage down with “lazy” cash that would be sitting in your checking account earmarked for household bills.
By putting more money toward the debt sooner, you reduce the amount of interest paid. Interest is computed on a daily balance, so the borrower can save sooner in the cycle. Paying less interest means that more of your money can go towards principal, and the actual loan term is shorter. Borrowers with a significant monthly cash flow could pay off a loan in approximately half the time by following the plan and making extra principal payments.
These types of offerings are terrific only if you stay within your financial means and do not abuse credit. The underestimated challenge with these programs has been the lure of the line of credit — it’s simply too big a carrot. Consumers have not shown the discipline to prepay early and many spend more than they can afford by tapping into available home equity for toys and vacations.
A company offering a similar program is Bellevue, Wash.-based Liberty Financial Group. The Liberty Equity Advantage Program (LEAP) is tied to the prime rate or 1-month LIBOR rate, plus a margin. According to LEAP calculations, a borrower with a $300,000 loan at 6 percent could reduce the loan term from 360 months to 236 months by following the plan and adding $500 per month to the housing payment.
The Liberty Equity Advantage Program combines an interest-only (first 10 years), variable-rate loan with a line of credit. It allows consumers to borrow up to their limit and repay as they choose (as long as they meet their minimum monthly obligations). Like most lines of credit, the interest rate varies with the market.
Borrowers make interest-only payments for the first 10 years. Then, the loan limit will begin to decrease at 1/240th per month (the remaining 20 years) and borrowers could have to make principal payments to comply with it. How that will affect their monthly balance depends on their loan balance in relation to their credit limit at that time. If the balance is higher than each month’s new credit limit, the borrower must pay the difference in addition to the interest. But, if borrowers have paid ahead on their loan balance (via direct deposit of payroll checks or other funds) they will continue to pay interest-only payments until their credit limit reaches their balance.
Look at it this way: Every time you make a direct payroll deposit or add funds from another account you are in effect “making” a payment because it immediately reduces your balance. At the end of each monthly statement period, the program adds an interest charge based on the daily principal balance.
I am all for paying off your home early. But before you enter into any new loan, perform a reality check and be honest about how you would handle having access to most of your home’s equity all the time. Subprime loans did not send this county into a mortgage funk, as only about 13 percent of all subprime loans are in trouble. Our current mortgage situation is a direct result of consumers borrowing amounts they could not afford to repay.
As my Mom used to say, “If you put it on your plate, be sure you can eat it.”
To get even more valuable advice from Tom, visit his Second Home Center.