The Truth Behind Mortgage Acceleration Programs

© 2008 Neill Clayton-Smith

 

Relying on a borrowers lack of financial know how there are a number of programs marketed claiming you can save thousands of dollars in interest and pay off your mortgage years earlier if you purchase their product.  While these programs make it appear that the borrower could not accomplish the same benefits by themselves, in actual fact the principals behind the programs are relatively simple and the same effect can be achieved with a little knowledge.  This article will provide that knowledge.

 

The systems seen so far involve paying the mortgage faster than the current amortization schedule.  When additional principal is paid on the mortgage the borrower effectively invests their available cash at the rate of the mortgage, reducing the duration and saving the interest payable over the balance of the mortgage term.

 

The following are the details of two systems I have come across.

 

 

Bi-weekly mortgage payments

 

In this program the lending or bill pay institution has you subscribe to a service that will take bi-weekly payments out of your account and make your mortgage payments, saving your thousands in interest.  There is usually a one-time fee of a few hundred dollars or a monthly fee for this service.

 

In the advertising the 'bi-weekly' deduction is touted as the 'magic' that allows the fantastic savings in interest.  The truth is that the result of the 'bi-weekly' payment is an extra mortgage payment a year.  If you made 13 mortgage payments a year in place of the typical 12 (one a month) you would achieve similar results.

 

Many people confuse 'bi-weekly' with twice a month, but this is not the case.  There are 52 weeks in the year, by making payments every other week you would be making 26 payments.  Normally you make 12 mortgage payments, if these were split in two it would result in 24 payments, not 26 !!!

 

So lets see some examples:

 

Mortgage: 120,000

Interest:  6%

Term: 30 Years

Monthly payment:  $719.46

 

	Regular mortgage	Bi-weekly	One extra principal payment  (#1)
Actual loan duration	30 years	24.5 Years	24.3 Years
Total interest paid	$139,006	$109,319	$108,391
Interest savings of regular mortgage		$29,687	$30,609

 

#1 This assumes the extra principal payment is made at the beginning of every 12 month period.  If made at the end the result is slightly worse than the bi-weekly approach.

 

Summary

 

Assuming you want to make an additional mortgage payment a month, how do you do it without paying for any bi-weekly program?

 

Simply take your current mortgage payment and add an additional principal amount of 1/12 of the existing payment.   For example on the $719.46 payment above

 

            New payment = $719.46/12 + $719.46

                                    = $59.96 + $719.46  ==> $779.42

 

 

 

Home Equity Loan Programs

 

There are a number of programs where you are required to setup a home equity line of credit (HELOC) against your property, depositing your paycheck into the HELOC and making all outgoing payments from the HELOC.  In other words use the home equity line as a checking account.    You keep your existing mortgage and you will be told when to make additional mortgage payments from the HELOC.  There is usually software supplied with this that tells you when to make extra mortgage payments making sure the HELOC does not drop below zero. In other words you want to make sure you are always borrowing against the HELOC.

 

 This program can be broken down into three components.  

1. Making the extra mortgage payments
2. Tracking your cash flow and applying available cash to the mortgage.
3. The benefit gained from borrowing on the HELOC to make an additional mortgage payment

 

The advertising for this program goes into a lot of confusing details, but the results stated come almost entirely from regular prepayment of principal.   The comparisons made are against the original mortgage, not how much better this program performs than any other prepayment schedule.

 

Item #1 - As shown in the bi-weekly example, paying a mortgage off in an accelerated manner can result in some large savings over the life of the loan.  The program claims regarding the potential savings are valid, but these savings are just due to the additional principal payments made, not any other 'magic'

 

Item #2 - The principal here is to take monthly income and subtract all monthly expenses to calculate available cash.   Apply this cash as extra principal payments on the mortgage to pre-pay the mortgage and reduce the term and the interest costs.

 

Item #3 does not provide a significant benefit over the life of the loan.  Borrowing the money from the HELOC and using the salary to reduce it as quickly as possible to avoid interest does not save a significant amount over the period of the loan.  This saving is completely obliterated by the high costs of the software.

 

Now for some examples.

 

Mortgage: 120,000                                                           Income: $5000

Interest:  6%                                                                 Monthly expenses: $4000

Term: 30 Years                                                            Available cash: $1000

Monthly payment:  $719.46

 

	Regular mortgage	Extra principal payment with free cash (each month)	The HELOC approach  (#1)
Actual loan duration	30 years	7.25 Years	7.17 Years
Total interest paid	$139,006	$27,954	$26,893
Interest savings of regular mortgage		$111,052	$112,113   (#2)

 

#1  The HELOC approach is the marketed scheme where a large principal payment is made from the HELOC (Usually some multiple of available cash) and this is then paid down until the HELOC is close to zero.  The process is then repeated.  Thus in the example above we have chosen $5000 as the initial payment, we pay down the HELOC over 5 months since our available cash is $1000 per month. We then make another $5000 payment from the HELOC.

 

#2 These figures do not take into account the costs of borrowing money from the HELOC.  As can be seen above the difference in total interest paid between making the large payment up front or just making extra principal payments monthly is approximately $1000.  Since these programs usually costs in excess of $1000 it would not be worth while, even if there were no costs in borrowing money from a HELOC.

 

 

Summary

 

In summary, there is no significant benefit in having the HELOC or the software.   A borrower will get similar results by balancing their checkbook at the end of each month, working out their available cash flow and making an additional principal payment with the available free cash.

Obviously it is a good idea to have an emergency fund available, so if the borrower is not going to carry a cash cushion a HELOC may be a good idea for emergencies.

 

 

Note:  Make sure that you mortgage does not have a pre-payment penalty for making additional principal payments.

 

Note: Consider how the additional payments compare to your other investments.  You are effectively investing your money at the rate of the mortgage for the duration of your mortgage.   It may help to discuss your plans with a financial advisor.