How to Save money on Mortgage - Tip 2 (Benefit to you varies)
Mortgage Tip #2:
There are two schools of thoughts when it comes to paying on Mortgage debt. One, who use the "Renter's model" and compare monthly mortgage payments to monthly rents they would be paying if they were renting a home instead of owning it. So naturally they like to reduce the monthly mortgage payment and tend to not pay towards the principal. The second school of thought is 'debt is a debt'- it costs money. I belong to the second camp. I hate to keep paying interest on the debt though it brings me excellent tax benefits. I am never able to make sense in buying a home purely on the tax exemption of the interest expense. You spend say 1000 dollars and get 300 dollars worth of tax savings. Still you are spending 700$ that is never going to come back to you. (I have a better offer for you: you give me 1000$ and I will pay $900 towards your taxes- That is three times better tax savings compared to paying it in form of interest on tax loan!). Do not misunderstand me- I am not against mortgages or buying a home. I am just trying to make a point that do not purchase a home just because if offers tax benefits. My principle would be look at the value of the home and seek a bargain.
Anyway, here is a tip for the person who subscribers to second school of thought. I think people who believe in "Renter's model" would also benefit from this.
Let us say that your mortgage loan is for 400,000 at 6% for 30-years fixed starting from January 1st, 2008. Your monthly payment is $2398 for 30 years- 360 months. I am assuming besides money for mortgage payment, you would be keeping some money in bank CD or in bank accounts to meet your liquidity needs. That money usually brings in 2-3% per annum and on that small interest, you pay taxes too! So let us assume your post-tax return for on-hand money and CDs is 2%. I am not against it. I am not going to advise that you do not need that kind of money on hand for a rainy day. You actually need it.
Let us assume you have 15,000 in bank accounts and bank CDs yielding 2% compared to 6% you are paying on mortgage debt. In my opinion, this 15k is costing you 4% per annum. Let me propose an alternative. Again, I am going to assume that you have good equity in your home.
Have you heard about HELOC? Home Equity Line of Credit? This is not the traditional Home Equity loan. This is a Line of Credit which is usually available at the PRIME rate. As of today, you can find HELOC at around 5%. You can draw out of the account when you need and you pay interest only on the amount you withdraw. In ideal situation, I am going to ask you NOT to withdraw money out of HELOC account; just keep it as a lender of last resort for a rainy day. (If you have high interest credit card loans, auto loans or student loans, I think you should look at paying them off using HELOC funds. HELOC not only has lower rates of interest, but that interest is also tax exempt like mortgage interest.)
Let us get back to our original topic. Your 30- year fixed will have last payment as on Jan 2038. By that time, you will have paid 463,352 in interest only on your 400,000 original loan. Including principal, you would have paid $863,352.
Now let us assume we have a HELOC so we decided to pay off 15,000 off of the 1st mortgage with the money we had in bank account and bank CDs. That money was there as a buffer and now with this Line of Credit, we have access to the same kind of funds if we had emergencies. So nothing changes as such except that your bank accounts have not much cash now. Remember you are not drawing money from HELOC either. It is there just for emergencies.
So how does the new scenario look?
Outstanding principal on your 1st mortgage is lower by 15k now. For simplicity, let us assume that it is now 385k instead of 400k. So you have better equity in the home now. Your Loan to Value ratios are also favorable as on paper you have better equity in your home! Yahoo!!
That is not it though. By paying off 15k on say April 2008, your 30 year fixed mortgage is now only 27 years and 2 months!! Instead of 360 monthly payments, you will be paying only 326 monthly payments. 34 less monthly payments!! At $2398 per month, that is a savings of $81500 overall!!!
Over the full term of the loan, there is a potential for reducing the overall interest expense from 463k as shown in image 2 to 396k as shown in image 3. So that 15k you are keeping currently in your bank accounts can save 66,000 dollars worth of interest cost!!!
Does this make sense? This is too simplified just to highlight some financial calculations and show the power of compounding. This calculation assumes that you have enough equity in your property to get HELOC at good rates. For full benefit, it assumes that you are staying this home for full 30 years term. Biggest assumption is that you are not going to draw on HELOC for vacation or for purchase of an SUV or a boat.
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