Mortgage Payoff

Just about everyone has a dream to be “debt free” from their mortgage payments; however, making that dream a reality may be more simplistic in concept than in practice.  For this reason a number of companies have introduced products that claim to have the ability to reduce debt, without impacting your routine spending habits.  You may have heard advertisements offer things like “It’s not Magic, It’s Math” or “Our New Interest Cancellation System will help you pay off your debt in a third of the time.” As a matter of fact, each of these companies, in one way or another, will tell you that paying off your debt is easier than you think.  All you have to do is implement their strategy, which will be based on several high level algorithms developed by highly educated mathematicians or engineers from schools such as MIT or Harvard.  Regardless of who develops or offers the product, those involved all believe that they are the best at what they do; and why shouldn’t they believe it?  If I put my heart and soul into selling a specific product I would have to believe in the product in order to effectively sell it.  Consequently, it will be very difficult for most people to obtain an unbiased interpretation of what a mortgage acceleration program is or how the program works.  My goal is to give you that basic understanding, so that you can decide if it is the right choice for you or not. 

The most common mortgage acceleration strategies are placed into one of three categories: Bi-weekly payments, periodic principle reduction payments, and mortgage acceleration software.  On average, borrowers are familiar with the first two strategies, but often find themselves confused when it concerns understanding what a mortgage acceleration software program is or how it works.  I will focus the majority of my time on this option, because in general this is where I receive most of my questions related to this topic.

In order to fully understand how mortgage acceleration software works we must first make sure you understand a few basic mortgage-related concepts, such as:

1. I.                 An amortization schedule
2. II.             Interest offset
3. III.         Principle reduction

1. I.                 An amortization schedule

An amortization schedule is a data table that illustrates the details of your monthly loan payments.  The table will itemize the total amount paid towards interest and the total amount paid towards principle each and every month.  As with any other loan, you will be able to see that your outstanding principle balance decreases with every new payment that is made.  The lower your principle balance is the lower the interest payment obligation will be.  Obviously, if you reduce the amount owed on interest but continue to make the same fixed rate payments on your loan, the amount applied towards the principle balance will increase.  You can see that an inverse relationship develops between interest and principle with every payment made. 

For example, let’s go ahead and assume that you have a 30 year, 6% fixed rate mortgage, with a principle balance of $300,000.   Your monthly payments for a loan like this should calculate out to $1798.65.   After making your first payment you will see that $1500 is applied towards interest and $298.65 is applied towards principle. Once these figures have been applied, your new principle balance will have dropped down to $299,701.35 ($300,000 - $298.65).  The lowered principle balance will reduce the amount of interest you pay on your next payment.  You pay less in interest because your new interest calculation will now be based on $299,701.35 versus $300,000.  Therefore, your next payment will have a slightly lower interest cost and a slightly higher principle reduction amount.  Your interest cost will continue to drop and your principle reduction amount will continue to increase with every new payment you make.  This process will go on for another 358 payments, at which time you will have paid off your $300,000 balance on the loan plus an additional $347,514 in interest charges.  Most people would cringe upon seeing such a total, but you should keep in mind that you have borrowed a large sum of money up front that is to be paid over time. 

PUT IN AMMORTIZATION SCHEDULE FOR PAYMENTS 1-5 and 355-360 FOR ILLUSTRATION PURPOSES

1. II.             Interest offset

Interest offset simply refers to an interest cost reduction technique, in which a borrower reduces their principle balance on an existing loan, at the beginning of the month, by applying any and all income received as a payment on the loan.  Then, as expenses materialize, the borrower uses the available credit on the loan to pay these costs as they occur.  Because interest is typically compounded daily, the amount of interest due on the loan will be lower at the beginning of the month due to the principle reduction that was done.  Then, as the month continues and expenses are paid, the interest cost calculations increases to its normal levels.  However, the average monthly principle balance will be lower, thus allowing the borrower to apply more of their payment towards principle instead of interest. 

Confused yet?  Perhaps if we run through an example it will help clarify.  Let’s assume you have an account that allows you to draw out funds whenever you want (ex. Checking account).  Most Mortgage Acceleration software programs will recommend a Home Equity Line of Credit (HELOC) to accomplish this task.  In this particular example our Home Equity Line of Credit was approved with a $25,000 maximum credit amount.  You decide to use $5000 as an advance withdrawal to propel the acceleration process.  You choose this amount because it happens to be the exact amount you are paid each month.  In the first month rather than applying a normal payment of $1798.65 you decide to apply $5000 instead, which has been provided for you from your Home Equity Line of Credit, to the $300,000 mortgage in the original scenario.  Once the payment has been processed your new principle balance on the mortgage will be $295,000 and your principle balance on the Home Equity Line of Credit will be $5000. I hope that you are still following me at this point.  Now, for this example, we are also going to assume that you have just received your monthly pay check, and instead of depositing your money into a checking account you write out a $5000 check to your Home Equity Line of Credit.  This will bring the principle balance on the Home Equity Line of Credit back down to a zero.  Therefore, on Day Two your principle balance on the mortgage is $295,000 and your principle balance on the Home Equity Line of Credit is $0.00. This is a good time to point out the obvious.  Simple math will tell you that the interest accumulated on $295,000 daily will be lower than the interest accumulation on $300,000 daily.  We have begun the interest offset process. 

We have now reached our first obstacle in this process.  If you were to use your entire paycheck to pay down your HELOC then wouldn’t you be left with insufficient funds in your checking account, to pay your other bills as they become due?  The solution to that problem is simple: don’t forget your HELOC will work in the exact same capacity as your checking account and as your bills become due, you would simply pay those bills using your Home Equity Line of Credit. 

The total amount of interest paid on the $295,000 plus your expenses as they arise during the month will still be less than the total amount of interest due on $300,000, compounded daily over 30 days.  The difference between the accumulated interests of these two loan amounts will be the amount of interest offset by implementing this technique.  Maximizing this strategy to its fullest potential is the premise for most Mortgage Acceleration software calculations.

1. III.         Principle Reduction

Principle reduction is the process of reducing the total amount owed on a loan by adding additional principle payments to your standard monthly payment amounts.  By adding additional payments to your normal monthly payments, you accelerate the payoff date at a pace determined by the amount and frequency of the increased payment amounts.  In short, the more you apply towards your monthly payments and increase the number of times you do it, the sooner you will be able to pay off your loan.

Hopefully, at this point you have a general comprehension of what an amortization schedule is, how interest offset works, and the benefits of principle reduction.  By understanding these three concepts you will have a sense of how the mortgage acceleration software works.  Note: it is not rocket science - it is simply manipulation of interest over time.  But first there are a few guidelines that must be established before you can effectively use a mortgage acceleration software program:

1. You will need to earn more than what you spend.  Most mortgage acceleration software representatives will tell you that it can still apply the program when you are “breaking even” every month, but the simple fact is that the costs of the programs do not outweigh the benefits in these situations.  If you don’t have a positive cash flow it is in your best interest to wait until your circumstances change before buying an acceleration software package.

1. You will need to be disciplined on how you manage your money.  In order to maximize your benefits in this program you are required to follow the program to a “T”—that means no unnecessary spending or careless practices when dealing with your finances. 

1. You will need to have access to an account that you can draw on, to pay your expenses as they come due.  Most programs require a Home Equity Line of Credit but other financial instruments can be used, provided that it allows you easy access to draw funds. 
2. You will need to refrain from refinancing your debt in any way.  It defeats the purpose of paying your debt off if you add more costs and extend the terms of your current debt.

We are now ready to show you how the Mortgage Acceleration Software works.  Hopefully, you have paid special attention to the interest offset section, because in its simplest form it is what a mortgage acceleration software program does.  This software program will optimize your payments in a manner that allows you to pay as much as possible towards principle, and as little as possible towards interest.   Implementing this strategy will in turn help you decrease the principle balance more quickly than any other conventional payment practices. 

In order for the software program to work at its optimal levels, it will prompt you to pay as much as possible towards the principle balance at the beginning of the month.  Typically, you will be asked to deposit your entire paycheck to fulfill this request.  Then, as expenses arise, you will pay those expenses by using proceeds from a designated debt instrument, such as a home equity line of credit.  As the month progresses, you will see the principle balance on your combined debt increase, which, consequently, increases your daily interest cost on the loans.  The benefit of starting the month with a lower principle balance is that the total interest obligation for the month will be calculated on the average principle balance for the month, which will always be lower than doing nothing at all.   

If you do nothing but follow the conventional mortgage loan repayment plans, the principle balance of your mortgage loan will remain constant, from the beginning of the month to the end of the month.  You will also deposit your paycheck into a standard checking account, and as expenses add up you would simply pay them as you normally do.  This would hold true for your mortgage payment as well.    When the mortgage loan payment becomes due you would simply write out the check and send it in. 

In this situation the interest calculated on the mortgage loan will be at a higher cost than the interest calculated using the principle reduction strategy.  Therefore, as you make that payment the amount applied towards interest will be higher and the amount applied towards principle will be lower.  In essence, your principle balance will be reduced at a slower, more gradual rate, which is why mortgage acceleration software has gain so much momentum over the years. 

The mortgage acceleration software program will increase the amount paid towards principle, allowing consumers the ability to lessen their payoff terms.  Another benefit to this program is that you will not need to modify your regular spending habits; instead, the program will educate you on when and how to effectively spend.  Let’s take your through one more example. 

We will use the same terms from our previous examples.  Your payment is still $1798.65 and your loan amount will still be $300,000.  Using the conventional payment process the average balance on your mortgage loan for the first month will be $300,000, the exact amount you borrowed.  Your amortization schedule will show that $1500 applies towards interest and $298.65 will apply towards principle, leaving you with an ending balance of $299,701.35.  Using the mortgage acceleration software exactly as instructed you discover that you have been able to drop your average monthly principle balance from $300,000 to $296,500.  After making your $1798.65 payment you should see that the amount being applied towards interest and principle changes.  Your amortization schedule now shows that $1484.73 will be applied towards interest and $313.92 will be applied towards principle.  Can you see the difference?  You would have an additional $15.27 applied towards principle that you did not have using conventional repayment practices.  Now, the $15.27 by itself is not substantial, but if you calculate that savings compounded month after month, you will soon realize the savings on your total mortgage loan obligations.  You will eliminate years of payments saving you tens of thousands of dollars.

The mortgage acceleration software industry has many competitors, all of which essentially offer the same strategies at varying costs.  The amount you save using the software as compared to doing it yourself is not significant enough to warrant any exaggerated costs; the real decision you need to make is how much you are willing to spend in order to achieve peace of mind.  If you decide to tackle the mortgage acceleration software strategy, make sure you are talking to someone who understands the strategy and is not focused on their own ambitions.  I have talked with many people who promote these products and I have only been impressed with a select few; meanwhile, the remaining individuals were in it for the money.  If you need the constant discipline of someone or something telling you exactly what to do and when to do it, then the mortgage acceleration software is tailored for you. 

A word of caution: do not allow yourself to be double-talked into a costly program by someone promising you the world.  It is not “magic” - it merely simplifies a complex strategy so that you do not have to do it on your own.  Most of these programs will do the same things.  The differentiating factor between competitors typically involves the same thing seen in other industries, which is the service provided.  You will want to preview the product and choose the product based on the features and service you expect to get from a product of this nature.  Finally, look at the costs and compare other products before making a final decision.  You will eventually be able to determine what a program like this is worth to you.

There are two other strategies used by lenders and consumers for mortgage acceleration:  bi-weekly payments and periodic principle reduction strategies.  These two strategies are easier concepts to understand, but we should still take a few moments and see how these simple practices can save you tens of thousands of dollars on your mortgage payments. Bi-weekly payment strategies have been in place for as long as I can remember and are currently offered as a payment option by most reputable lenders.  If a lender does not provide the service, you can simply set one up, using the auto-pay features from your checking account.  In one way or another you can implement this simple strategy on your own.   You should take your current mortgage payment and divide it into two, half payments.  These half payments will need to be made every two weeks, which should fall in line with your paydays.  By making a payment on your loan every two weeks you will have made 26 half payments (or 13 full payments) per year.  Using the traditional conventional payment methods you will only produce the required 12 payments per year.  As you can see, setting up payments bi-weekly enables you to make one extra payment per year.  The extra payment will be applied towards the principle, which will then reduce the principle balance at a greater rate than conventional payment methods. 

Using a Bi-weekly payment strategy will reduce your payoff term from 30 years to 23 years, ultimately saving you seven years worth of payment obligations.  You don’t have to be a math expert to calculate the savings here.  You will save over $115,000 over the life of that loan.  Another benefit for using the bi-weekly approach is that it can be a good budgeting tool for people on a budget who still wish to pay their mortgages off early.    

Finally, we should take a look at how a periodic principle reduction strategy will allow you to accelerate the repayment process on your mortgage loan.  To be honest, there is no real strategy to this practice: borrowers simply send in more money whenever they can.  The extra funds, which are added to the mortgage payment, should be applied directly to the principle balance of the loan.  I will tell most of my clients to include a separate check with their payments when applying a periodic payment.  You should also include a note, informing the lender of specific instructions for how to apply the extra funds directly to the principle balance.  The purpose of doing this is to avoid any misunderstanding from the lender on how these funds are to be used.  Periodic payments can be made in a number of ways.  Most people will send in their income tax refunds once a year to have that applied to the principle.  Whatever the reason might be, applying extra funds to your principle will help accelerate your payoff process.  The exact acceleration will depend on the frequency and the amounts you applied to your existing principle mortgage balance.  The greatest benefit here is that you can pay extra when you have the desire and means to do so.  You will not be locked into anything, so you will have the freedom to pay when you want and how much you want.