May 19, 2013 in Business

Prepayment plans surface with increased home values

Tom Kelly
 

A financial planner once told me that people really did not 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.

Solicitations for biweekly payment plans have become common as some borrowers look to pay 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 their loan. The mortgage broker is offered an incentive, typically $300, to “sell” the program to his customers. The truth is borrowers can do it themselves for free by prepaying each month.

The sales pitch typically focuses on the ability to accrue equity faster, saving thousands of interest dollars, maintaining a better credit rating because electronic transfers are rarely late and a hassle-free prepayment amortization schedule generated by the lender.

Sometimes, the original lender will offer a biweekly program at no cost to the borrower. To qualify, borrowers usually are required to authorize an electronic transfer of half the monthly payment every two weeks. The extra money is then applied to the principal of the loan. Interest savings can differ depending upon when the payment is applied to the principal.

Families could save thousands in interest dollars by paying off the mortgage sooner via two payments a month rather than the single monthly payment. A total of 26 biweekly payments are made instead of the usual 12 monthly payments, amounting to an “extra” month’s payment every year. Depending upon the interest rate, borrowers could save six years of payments on a 30-year loan.

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 earlier 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. 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.

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.

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