No Gimmicks Needed to Pay Off a Mortgage Early
When Humberto Cruz paid off his $100,000 California mortgage early 19 years ago, he saved an impressive $97,468.70 in interest.
The columnist for the Los Angeles Times and his wife did so themselves and at no cost, simply by enclosing a second check with what they could afford with their regular mortgage payment each month. Along with this check, they sent instructions to use the extra money to pay down the principal.
This is basic math.
The less principal you owe on a home loan, the less interest you’re charged as part of each regular payment. As a result, more of each payment goes to further reduce the principal balance. If your goal is to pay off your home mortgage early (it may not be for everyone), you can do it without having to fall for a gimmick that overstates savings or hides the actual cost.
And there are plenty out there.
“Pay off your mortgage in 15 or even 10 years without having to change your current lifestyle,” is a typical pitch among several we’ve come across.
Although details vary, the essential idea is to turn your home loan into what amounts to a “cash-flow management account” that works like a bank.
You do it by depositing your entire paycheck and any other income you get “into” the mortgage — that is, putting an extra mortgage payment into the cash-flow account. All deposits immediately reduce the outstanding balance on your loan. As you need money to spend and make withdrawals from the account, the balance goes back up.
The concept is intriguing, the setup convenient. The companies promoting these programs typically offer free online bill-paying and free debit/ATM cards as easy ways to make withdrawals, in addition to unlimited paper checks. The math, too, would seem to work. If you are depositing more than you are taking out and doing so regularly, you’ll save more in interest than if you simply send extra payments to the principal occasionally.
By having your money deposited directly into these accounts, you create an element of discipline and forced savings that’s often lacking when you must remember and decide to pay down the principal on your own.
The problem is that the literature about these plans is often misleading, comparing apples and oranges and enticing homeowners into home mortgage refinancing taking on a home equity line of credit that provides for the unlimited checking, bill-paying and ATM access.
Through fuzzy math, this home equity line of credit, which charges a higher interest rate than the mortgage, is made out to be a brilliant savings move.
For example, one program boasts that a person paying 6.5 percent interest on a 30-year, fixed-rate mortgage of $300,000 could have the mortgage paid off in 15 1/2 years by using a cash-flow management account tied to a variable-rate home equity line of credit charging 7.72 percent to start.
To see the same savings made possible by the early payoff, a homeowner would have to find a 30-year home mortgage at an interest rate of just 3.83 percent, marketing materials claim.
In reality, what makes the early mortgage payoff possible is not the establishment of the line of credit, but the assumption that the person can and will save $800 a month into the cash flow management account. So why not simply keep the existing mortgage at 6.5 percent and send an extra $800 into the principal each month?
“If the person were to apply that $800 in savings toward the existing mortgage instead of refinancing into the newfangled home equity line of credit, the result would be paying off the mortgage in 14 years and three months,” or 15 months earlier, said David B. Jacobs, a financial planner with Pathfinder Financial Services LLC.
Not just that, but the homeowner would save an additional $45,000 in interest over the life of the loan compared with the line of credit.
Besides the line of credit costs, a one-time fee for setting up these cash flow accounts can run as high as 1 percent of the loan balance. If you were to apply to the mortgage principal the fees saved by not using one of these services you could reduce your mortgage payoff time by another year.
These schemes take the simple idea of making extra payments toward your principal and make it look more complicated so they can charge for what you could simply accomplish on your own. Don’t be deceived!