Baltimore Real Estate Investing Blog

Guest Post

I met Jeffrey Smith, on the bigger pockets website.  One of his websites Ultimate Online Bargains has a number of in-depth articles. It’s worth checking out.  Jeffrey has allowed me to share this one here.

Mortgage Accelerators

Recently, there seems to be a viral spread of so-called “Mortgage Accelerator” products, which promise miracles of drastic reductions in the interest expense and pay-off time of your home mortgage. These products are usually quite expensive and they perform no miracles. The producers of these products are preying on the financial illiteracy of the general population.

The products are of a form similar to a spreadsheet. Some products operate on the internet through a web browser and others run directly on your computer without an internet connection. Some products are sold (i.e., licensed) for a one-time hefty fee and others are subscription based (you pay monthly for the privilege of using their software).

The typical hype for these products claim to reduce a 30 year mortgage to about 10 years or less, with no change in: Your lifestyle, your income, or your monthly mortgage payment. That means that whatever your income and expenses are now, you can pay-off your 30 year mortgage in 10 years (give or take a year or two) without reducing your expenses, or increasing your income, or changing your monthly mortgage payment.

Such claims are designed to exploit the financially illiterate.

Here is how the latest batch of nonsense mortgage accelerator programs work:

1. Open a revolving unsecured signature credit line with your favorite bank. The credit line needs to be about two or three times your monthly net income after taxes. The interest rate is irrelevant. Let’s say it’s a generous 12.0% annual, compounded monthly (1% per month on outstanding balances).
2. Connect the signature credit line as overdraft protection to your checking account. Any overdrafts on your checking account will draw from the credit line.
3. Deposit your monthly pay into your checking account.
4. List all of your monthly expenses into the program, including your mortgage parameters (term, interest rate, monthly payment, etc.).
5. The program then proceeds to generate a list of what payments you should make to what accounts, including a “normal” payment (principal and interest) to your mortgage and a principal-only payment on top of the normal payment.
6. The program is designed to tell you to invoke the overdraft protection feature to borrow a generous amount of extra money to pay towards your mortgage.
7. Your monthly income is zeroed out each month to pay your expenses. After paying your normal expenses, any excess amount of income goes back into your credit line to pay down the excess debt that your borrowed for your principal-only payment on your mortgage.

The process is repeated each month. You tell the program your expenses for the next month, your income, and the program tells you what to pay for your expenses and your normal mortgage payment, and then the program decides whether to tell you to pull another big chunk of money from your credit line to pay as principal-only on your mortgage. If you are not pulling a big chunk to pay principal-only, then any cash left over from your monthly income after paying your monthly expenses will go towards reducing the debt on your credit line. After a few months, your credit line is zeroed out, and the program tells you to pull another big chunk to pay principal-only on your mortgage.

Note: At no time will the program have any access to your checking account. The program is only advising you on what checks to write from the data that you tell it. You must tell the program what checks you wrote for what expenses, and your net income for each month. The program then tracks your income and expenses, and calculates the balances on your mortgage and credit line (from the data that you input).

What if you are living paycheck to paycheck and don’t have any excess income? Forget about it! These accelerators only reduce your mortgage at an accelerated rate when you pay more principal.

Now, let’s look at what is really happening.

1. Let’s start with a mortgage of $200,000 principal balance, 30 years (360 months), 6.0% annual interest compounded monthly, and a monthly payment of $1,199 (rounded to the nearest dollar).
2. This mortgage is a level payment, so the principal and interest components of each monthly payment will vary and the total of principal plus interest is always the same amount. As the principal balance reduces each month, the principal component of the next payment increases while the interest component decreases. This is easier to understand when you print a full amortization schedule for all 360 payments that shows the principal and interest components and the running principal balance on the mortgage.
3. Suppose your monthly income after taxes is $5,000 and your monthly expenses are $4,000 including $1,199 for your normal (principal and interest) monthly mortgage payment. You have $1,000 excess cash left over after paying all of your bills for the month.
4. Your first normal monthly mortgage payment is $1,000 interest and $199 principal. Your mortgage annual interest rate 6.0%, so your monthly interest rate is 0.5% on the balance. Calculate 0.5% of $200,000 is $1,000 interest. Subtract the interest from the $1,199 payment leaves $199 that is applied to principal for the first month.
5. Month #1: You tell the program your net income is $5,000 and your expenses are $4,000. The program advises you to pull, say, $6,000 from your checking account (using overdraft protection) to pay principal-only to your mortgage. The program also advises you to pay your $4,000 expenses, including your “normal” monthly mortgage payment of $1,199.
6. Your checking account now has a negative balance, showing an amount owed on your credit line of –$5,000 = $5,000–$4,000–$6,000.
7. Your mortgage balance is reduced to $193,801 = $200,000–$6,000–$199.
8. Month #2: You deposit $5,000 into your checking account and pay your $4,000 expenses. Your account has a negative balance of –$4,050 = $5,000–$4,000–$5,000–$50. You are charged 1.0% (12.0% annual) on the –$5,000 principal balance owing on the credit line.
9. Your mortgage interest is $969 = 0.5% of $193,801. Subtracting $969 from your normal $1,199 payment calculates $230 principal payment. Your mortgage balance is $193,571 = $193,801–$230.

The process is repeated until the negative balance on your credit line is zeroed out (or near zero), then another big chunk of money is pulled from your credit line to pay principal-only to your mortgage in addition to your normal monthly payment.

This is technique will pay-off your mortgage faster than just paying the normal monthly payment. However, it is actually costing you more money compared to simply paying the full $1,000 excess cash each month to your mortgage.

You pay $50 in interest charges on your credit line and you still have a –$4,050 balance owing on your credit line. Each month you will pay 1.0% of the balance owing on your credit line until it is zeroed out.

Your credit line is zeroed out from your excess cash flow after several months, after which you again borrow another big chunk of money at 12.0% to pay down your 6.0% mortgage. It is inane or insane, depending on whether you are trying to analyze it or save money with it.

Let’s compare side by side the mortgage accelerator to a direct pay down.

After 12 months, your mortgage balance is $185,054.10, you paid $14,945.90 in principal, $11,443.30 in mortgage interest, and $320.76 in credit line interest. The total interest paid is $11,764.06 for the combined mortgage and credit line.

After 12 months, your mortgage balance is $185,208.43, you paid $14,791.57 in principal, $11,597.63 in mortgage interest.

You paid $166.43 in extra interest to gain an extra $154.33 in principal pay down using the credit line. As the process continues, the extra interest you pay always exceeds the extra principal pay down using the credit line. You lose more money each month.

At the end of 36 months:

1. The credit line technique has paid down the principal to $152,339.98, you paid $32,597.04 in combined mortgage interest and credit line interest.
2. The simple accelerated pay down directly applying your $1,000 extra cash per month has paid down the principal to $152,832.08, you paid $31,999.68 in total interest.

Using the credit line technique, you paid $597.36 in extra interest to get $492.10 in extra principal reduction. You wasted $105.26 in extra interest payments. If you simply applied your excess cash flow to each of your mortgage payments, you would have an extra $597.36 available to apply as an extra principal payment at the end of 36 months. Thus, you can always beat the credit line technique by just paying directly instead of borrowing higher cost money from a credit line.

The results are not surprising that trying to pay down a 6.0% mortgage with 12.0% money is just plain stupid. The credit line technique requires paying higher cost extra money on your mortgage balance, and it won’t work at all when you have no extra money at the end of the month. It also won’t work when the mortgage has a prepayment penalty.

In the above example, both techniques will pay-off the mortgage in almost the same time, but the credit line technique will cost about $2,519.58 in extra interest over the reduced life of the mortgage compared to the simple technique.

Calculating the pay-off using the simple technique is just plugging in the higher monthly payment then solving for the number of periods. In this case, paying $2,199.10 each month, instead of the normal $1,199.10 each month, will pay-off the mortgage in 121.6 months (10 years and 1.6 months). In the above example, the credit line technique will also pay-off your mortgage and credit line in 122 months plus a fraction of a month.

If pulling $6,000 is good, then how about pulling $200,000 to pay-off your mortgage in one month? You then pay $2,199.10 per month for 241 months (20 years, 1 month) to zero out your credit line. Paying off low cost debt with high cost debt is stupid!

This is not rocket science. It’s simple time value of money using a financial calculator or a spreadsheet. You don’t need an expensive useless mortgage accelerator program to save time and money on your mortgage. You won’t save money or time by using the credit line technique. Just deposit your monthly income into your checking account, pay your expenses, then add any excess cash to your monthly mortgage payment. You will save money and time by just keeping it simple.

Besides being just a stupid idea, the programs for using a credit line are very expensive. The last pitch that I quietly sat through had a price tag of $3,500 as a one-time fee for perpetual access to a web-based program. The predators also had the audacity to suggest that you should pay the $3,500 price from your credit line! As if paying extra interest isn’t bad enough, they want their customer to start with a $3,500 deficit on their credit line! If you have the cash available, then you would be served much better by just paying the $3,500 on your next mortgage payment. I leave an exercise for you to calculate both the credit line and simple pay down, starting your credit line with a –$3,500 deficit and starting the simple pay down by paying $4,500 extra principal for the first month.

Very often, I see predators preying on financially illiterate people. The schemes are very savage and cruel, especially for young people. I see young couples attending the seminars of larcenous liars and wasting thousands of dollars that they definitely cannot afford to spend. The predators know that most people are usually maxed out on their credit cards. The first topic taught in the seminar is how to increase their credit card limit. The ulterior motive is to make room on the credit card so they can buy whatever is being sold at the seminar. These young couples are living paycheck to paycheck, probably raising very young children, and they get suckered into wasting their hard earned, precious money or getting trapped into an endless cycle of wasteful personal debt.

After seeing a viral spread of these outrageously priced, worthless mortgage accelerators, I thought it was time that I put my foot down and wrote this blog article as a warning.

Final message: Mortgage accelerators are worse than worthless, because they are designed by predators to prey upon the financially illiterate. There is no magic in paying off debt. The only way to pay less interest is to pay more principal. Shifting debt between accounts is meaningless without reducing the cost of interest.

Check out my Power Debt Plan spreadsheet for a simple inexpensive way to calculate the optimal paydown for your debt.

Jeffrey D. Smith is a real estate investor with an expertise for real estate finance. Jeffrey D. Smith provides real estate investment consultation to wealthy individuals on a private referral basis.