The current buzz term in the financial planning circles and also within the mortgage industry today is Equity Management. This is the term given to strategies that involve using your home's equity to fund investments, retirement plans, even the family car. Although the concept has been around for many years, one book in particular has spearheaded a new interest in these ideas. The book, written by Douglas Andrew, is called "Missed Fortune".
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That book was followed up with "Missed Fortune 101", an abbreviated version for the average consumer/investor and quickly became very popular with Financial Planners and Mortgage Brokers - two groups of professionals that clearly benefit when the strategies espoused by the author become accepted by a wider audience. We have seen Financial Planning firms offering an evening out (with dinner included!) for the opportunity to present these ideas to a groups of people at one time. Even the Chicago Federal Reserve has gotten into the act by releasing the results of a study regarding Mortgage Pre-Payment vs. investing in tax deferred retirement accounts.
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In my experience from working with hundreds of homeowners each year, while many homeowners may understand the benefits of applying such strategies, a large majority still prefer the peace of mind knowing that eventually, their home will be paid off. You can show theses folks all the charts and studies... but if the strategies presented are not relatively simple to deploy, most of them will not go through the necessary steps required of them. Sending extra principle payments is quite a bit simpler than opening new retirements and choosing investment vehicles that exceed the return gained through principle reduction. After all, we all know the return of principle reduction - it is equivalent to the interest being paid. Locking in a return of equal proportion considerate of the tax benefits may be readily available, but it's certainly not as simple as cutting an additional check each month!
While I also see benefits in deploying the strategies discussed in Mr Andrew's books, I have long been of the conviction that getting out of debt is a positive financial move for most people. When most people think of early principle pre-payments on a mortgage, the Bi-Weekly payment often comes to mind. I think the primary reason for it's popularity is due to two factors. First, consider how many people are paid on a bi-weekly schedule. It's an easy sell to someone that gets paid every two weeks to pay half of their mortgage payment every two weeks.
The second reason is that it's a fairly easy sell. A few companies figured out that they could earn a fee for helping people arrange their mortgage payments in this way. Then they figured out a way that they could pay a commission - no license required. So many people just hopped on the bandwagon and began selling this principle pre-payment strategy. They were told that it would cut 9-11 years off a mortgage thereby saving tens of thousands of dollars in the process. Sounds good,right?
Maybe.
It's probably better than doing nothing. But you can easily do this yourself, without paying a fee at all.
When you make bi-weekly payments, you end up making one additional mortgage payment each year. It does work - one extra payment each year will cut approximately 7-10 years off the tail end of your mortgage. There are 52 weeks in the year. Cut that in half and you have 26. 26 bi-weekly payments equals 13 monthly payments, get it? That's all there is to it.
So where's the rip off? The rip off comes when companies and consultants offer to assist you with the process. First, they charge a fee for setting up the account, from a low of 0 to as much as 0. Setting up the account simply means opening an escrow account. Then, they ask that you fund the escrow account with at least one monthly payment depending on when your next payment is due. See it's real simple - they take some money up front, then put you on the plan, paying one half of the payment every two weeks. By the time the first of the month rolls around, there's enough in the escrow account to make the payment. And get this... there's even a small charge for every escrow deposit - anywhere from - . Times that by 26 deposits and that will cost you an additional - 6 per year. For something you can easily do yourself.
The worst part of the story is yet to come. By the time the 12th payment rolls around, there's enough in the account to make one full extra principle payment. They wait until the end of the year before making an additional pre-payment! But mortgage interest is based on "Per Diem" meaning "per day". This simply means, the sooner you make additional principle pre-payments, the less interest is accrued. It would benefit you more to simply divide a full monthly payment by 12 and then add that amount to every mortgage payment!
Then, there's this to think about - the bi-weekly "consultant" controls hundreds, maybe thousands of these escrow accounts. How much interest do you think they are earning by holding all those accounts at a bank? Suffice to say, interest represents a 3rd income stream. No wonder there are so many companies offering bi-weekly payments!
There is another system that I have been showing my clients for many years now. I get phone calls from clients that I started on this system years ago and they are always thrilled with the huge reductions in their principle. It is based on the inefficiency of the amortization schedule. See, when you begin making payments on a 30 year mortgage, approximately 90% of the payment is interest! Yikes!. Each and every month a little more is applied to principle, a little less to interest. But it goes very slowly. Without extra principle payments, it will take 23 years for a borrowers payments to be split 50/50 principle vs. interest! Do you understand what that means? It means it will take you 23 years (approx.) to pay off 1/2 of your mortgage! The other half gets paid in the last 7 years.
Obviously, amortization was designed to benefit the lender...NOT the borrower.
The key to making amortization work for you instead of against you is to pay principle before it is due. When you pay principle early, the corresponding interest for the amount of principle paid early, is eliminated. Wiped out. Gone for good.
You need to start the process using your amortization schedule. If you do not have one, there are plenty of websites that offer them; just do a search for amortization schedule. If you have already made payments on your mortgage, that is ok, you simply need to know exactly how many payments you have already made. If you have already made additional pre-payments, it will be much more difficult to get a correct schedule.
When you look at a complete schedule, you sill see every monthly payment listed. You will see the total payment (not including taxes and insurance), the principle amount of each payment and the interest portion of each payment. The key to making early principle pre-payments is to make them very precisely - to the penny. This is the only way to stay on schedule so that you can track your declining balance.
It has been often pr oven that lenders do make mistakes when applying principle payments. That is why it is so important to keep track of your payments. The only way to keep task and to stay on schedule is by making what I call "Precise Principle Pre-Payments". A Precise Principle Pre-Payment is always equivalent to the principle portion of one or more future payments. Here's what I mean:
Say you are making a payment is April. The month doesn't really matter because once you begin on this system, you will begin to look at what payment you are on rather than the month of that payment. There are 360 payments in a 30 year mortgage. The trick is to accelerate the schedule so that you make way less than 360 payments. But using April as a starting point, you will be writing a check for April's total payment. Now, you want to pay some additional principle. The amount needs to be the exact amount of the principle column for future months. Remember, these will not be very high - roughly 10% of the total payment.
If you are in April as stated above, you would pre-pay May's principle. Again, to the penny. This is important because you will actually cross off April AND May on your schedule. Now this is important - YOU WILL STILL NEED TO MAKE A PAYMENT IN MAY. But in May, you will actually be paying June's payment because you paid May's principle in advance. Get it? Each month you make a payment, you look at the next month (or months), pay the principle tied to that month's payment and you accelerate on your schedule. If you pay the following month's principle each and every month, you will be going twice as fast as the amortization schedule calls for.
One Caveat - Make sure you do not have a pre payment penalty before beginning this program. If you have one, you may need to wait until your penalty expires. On the other hand, many mortgages that have penalties do allow for early principle pre -payments up to 20% of the balance each year. If you follow this schedule, you will be paying less than 20% of the balance.
You may also accelerate even faster by looking more than one month ahead. Taking the same April payment, you can pay May's, June's, July's principle early and accelerate by three months instead of just one.
The more you pay early, the greater the interest saved.
I realize that this may be somewhat confusing but it really does work. If you would like some assistance with this program, you may receive additional assistance, simply contact me and I will help you.
The Bi-Weekly Mortgage Rip Off
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