I had someone on the podcast a while back that was a big fan of mortgage acceleration for paying off your mortgage faster. Like a lot of complex financial products, those who can make a buck off of it say it's magic. They say things like, “Instead of paying off your mortgage in 30 years, you can pay it off in 7!” But when you dive deep down, you see that while there may be something worthwhile there, you don't have to pay too much in fees and extra costs to eliminate the benefit. Let's do a deep dive.
First of all, there's some confusion on the internet about what mortgage or equity acceleration really is. People are using the phrase for two different things. The first is a biweekly payment system. This is where you pay half your mortgage payment every two weeks (presumably as you get your paycheck.) By the end of the year (52 weeks long) you've made 26 half payments instead of 12 full payments. Plus, you're basically paying two weeks ahead, which saves a sliver of interest and slightly accelerates things. But the main benefit is just paying more than the minimum due. By paying that extra payment you knock a few years off your mortgage.
My calculations show you knock 4 years off of a 30 year, 4% mortgage or 16 months off a 15 year, 3% mortgage doing this.
Fair enough. Alternatively, you could just pay a little extra principal with each payment and get the same thing.
The problem comes when the lender or a third company charges you an extra fee to do this. That extra fee would reduce and perhaps even eliminate the benefit. So if you want to do this, just set it up yourself with an auto-transfer.
Using a HELOC
The real scheme I want to discuss is a little more complicated. It involves replacing part or all of your mortgage AND your checking account with a Home Equity Line Of Credit (HELOC). Say what? Don't worry, I'll explain. It's not that complicated. It's actually pretty clever, but it's not quite the magic bullet its proponents would have you believe.
Here's how it works. Let's say you get a mortgage. We'll make it a $400,000, 4%, 30 year fixed mortgage. Cool. You make that $1,910 payment every month for 360 months and you'll be debt-free.
But 30 years is a long time. So instead of just putting that mortgage on auto payment, let's say you did something else. You took out a $100,000 HELOC. Now you take that $100,000 and you pay down the mortgage with it. So now you've got a $300,000 4% fixed mortgage with a payment of $1,910. At that rate, you'll pay off the mortgage in 223 months, or just shy of 20 years. You knocked 10 years off your mortgage! Cool!
Wait. What about the HELOC?
Except you still have that $100,000 HELOC. Which is probably at a higher rate than your mortgage (perhaps 5%). And the rate is variable. And you probably had to pay for an appraisal and maybe even some other fees to get it.
Now your move doesn't sound so smart, does it? You just traded a lower fixed rate loan for a higher variable rate loan. HELOCs are also often interest-only, which is convenient, but if you just paid the minimum payment for 20 years, you'd still owe all $100,000 and you would have paid more interest over the years than if you'd just kept the boring old 30-year mortgage.
But here's where the fun comes in. Now instead of using a checking account paying you 0% and a savings account paying you 1%, you just use the HELOC. Your paycheck is deposited into the HELOC (decreasing the size of the debt) and your mortgage and other payments (hopefully consolidated on one credit card) are paid from the HELOC (increasing the size of the debt.)
Since interest is calculated based on the daily balance, there is usually LESS than $100K in debt. You do carry a balance in your checking and savings accounts, right? So if you've “got $50,000 sitting in the HELOC,” meaning you really only owe $50,000 on it, then the interest is half as much as it would otherwise be. And in fact it is LESS than what it would cost you even at a lower interest rate if you had just left the money in a savings account and earned 1% on it.
Think about it:
- 1 year's worth of interest on a $400K 4% mortgage = $16K, maybe $9,600 after tax, plus
- 1 year's worth of interest on $50K in a 1% savings account = $500, maybe $300 after tax.
- Put it together and you're paying $9,300 in interest.
- 1 year's worth of interest on a $300K 4% mortgage = $12K, perhaps $7,200 after tax, plus
- 1 year's worth of interest on a $50K 5% mortgage = $2500, perhaps $1,500 after tax equals
- $8,700 worth of interest.
Meanwhile, that extra $600 is going toward paying down that HELOC/mortgage combination even faster.
Perhaps you get the float on your credit card too. Let's say that gives you six weeks worth of $5K, which is a few dollars more.
And as the HELOC gets smaller, eventually you can take some more out of the HELOC and put it against the regular mortgage, further accelerating things.
Will that all help you to pay off your mortgage sooner? Sure will. But not magically. You see, in order to do the really magic stuff (some of these guys promise to help you pay off your 30-year mortgage in 7 years) there is one more part to the puzzle. That part involves paying more toward the mortgage/HELOC each month than you otherwise would have. If you spend less than you earn (which is a good thing that I'm very much in favor of) then that extra money sits in the HELOC. But that's precisely the equivalent of using the difference between what you earn and what you spend to send in an extra mortgage payment. Sure, you get a few extra days worth of interest savings messing with the HELOC, but the bottom line is you're making a bunch of extra payments without realizing it. It's a behavioral solution, not a mathematical one. I mean, alternatively, you could be investing that money and perhaps even making a better return than you're getting paying down your mortgage/HELOC and then turning around and paying off the mortgage with the investments once they equal the mortgage.
Interest Rate Risk
There are a few other risks that probably ought to be considered here. First, it's a variable rate loan. So if rates rise dramatically, you're now stuck with a HELOC at 6%, 7%, 8% or even higher. At a certain point, you're going to be better off with just your regular old fixed rate mortgage.
Another risk occurs if you don't actually spend less than you earn. In that case, all the wand-waving that fools you into paying extra on your mortgage works in reverse and you're actually using that HELOC as an ATM. The system works a little bit if you can only manage to spend exactly what you earn, but in order for it to really work, you've got to be “making those extra payments” by spending less than you earn and leaving the difference in the HELOC.
Another risk is that you could be passing up on better investments in order to pay off your mortgage early, which is generally considered a fairly low returning investment. Paying off a 4% mortgage when you could be earning 5%, 7%, 9% or more isn't exactly a winning move. It's a downright stupid move if you're missing out on an employer 401(k) match. But I would argue it could be pretty dumb if you're missing out on maxing out any type of tax-protected account. That tax break is huge for high-income professionals and I rarely advocate paying off a low rate mortgage if you're not investing anything in a taxable account. There's also an asset protection angle here. In most states, most of your home equity is available to creditors, but your retirement accounts are not. So you're missing out on additional asset protection too.
Risk of Picking Wrong HELOC
Yet another risk is that you might not pick a very good HELOC. Perhaps there was a 4.5% one available somewhere and you picked one that costs 5.5%. Or it has high fees.
Risk of Paying Too Much in Fees
In order to avoid that problem, some people hire a company to help them do this. That company picks the HELOC for you and teaches you how to do all this, but they want to make a profit too. Guess where that profit comes from? That's right, your pocket. The more you pay in fees, the less benefit you're going to see from doing this.
Credit Card Related Risks
It sounds like most people doing this are using a credit card. Not only do you get to “invest” the float, but you may also get some reward points. Two issues with that. First, the data is pretty clear that we spend more when we're using cards. If you really need or want to get out of debt, you're probably better off going to a cash budget. Second, most people who use credit cards don't manage to pay off the balance every month. You don't have to carry a balance on a credit card very many times before the cost of doing so outweighs any possible benefit you're going to get from a mortgage acceleration program. You won't be surprised to learn that Dave Ramsey thinks this is all a big scam.
Similar to Bank On Yourself/Infinite Banking
In a lot of ways, mortgage acceleration using a HELOC is similar to one way that insurance agents sell whole life policies. They encourage you to be your own bank, borrowing from the policy instead of keeping your money in a savings account. You try to mitigate all the downsides of whole life insurance and there are obviously some costs up front for 5 or 10 years. But in the very long run, you're basically earning 2-5% on your savings instead of 1%. And you get some sort of a death benefit depending on how much of the cash value you use. When you break through all the smoke and mirrors, that's basically what it comes down to. You pay a bunch of fees and opportunity cost up front in return for making a couple percent more on your savings in the long run.
The issue with both schemes is that their benefits are dramatically oversold (usually while minimizing the downsides) such that it causes many people to engage in them rather than doing something even smarter with their money, like maxing out retirement accounts. The minor benefits you do get with either scheme are probably just fair payment for the additional risks and hassle you took on.
An Alternative Mortgage Payoff Plan
So you're interested in being rid of your mortgage in 7 years instead of 30? Okay, you've come to the right place. I've actually got a little bit of experience in this. We paid our mortgage off in about 6 1/2 years. That's right. We paid off our home in less time than many of you pay off your educations. Maybe I should market The White Coat Investor Mortgage Acceleration Plan. Here are the components:
# 1 Don't overconsume housing
Keep your mortgage to less than 2X your gross income in the first place. Not only is it a smaller loan to pay off, but it improves your cash flow. And that's not even considering the transaction, insurance, maintenance, furnishing, repair, and upkeep costs associated with a more expensive home.
# 2 Put down a 20% down payment
Doctor loans are great, but there's something to be said for a conventional, 20% down payment. To start with, that 20% down reduces your mortgage by, well, 20%. You're already 1/5th of the way to your goal before you leave the starting line! Those financial muscles you used to deny yourself while saving up that 20% are also going to help you to pay off that loan faster. In addition, you have a lot more lenders to choose from and can get the very lowest fees and interest rate available.
# 3 Get a 15-year loan
We took out a 15-year loan. We refinanced it at no cost about a year later (which restarted the clock), but the point is that it wasn't a 30-year loan. Not only does that ensure we were making larger regular payments, but we also received a lower interest rate than we would have had on a 30-year mortgage, allowing even more of that larger regular payment to go to principle instead of interest.
# 4 Max out retirement accounts
We've always maxed out our retirement accounts. This allowed us to build wealth quickly and protect it from creditors. We NEVER paid extra on the mortgage while we had available retirement account space. Long-time readers know we have LOTS of tax-protected accounts available to us (over $200K in 2017), so that actually delayed us paying off our mortgage a lot more than it would most of our readers. But borrowing money at an after-tax rate of less than 2% in order to max out a Roth IRA invested aggressively or to take advantage of the tax rate arbitrage available in a tax-deferred account (and the asset protection available in most retirement accounts) is a no-brainer.
# 5 Send some of your taxable investment money to the mortgage company
Once you've maxed out your tax-protected accounts, it's a little more reasonable to pay down the mortgage instead of investing. Maybe you don't want to send in everything above and beyond the retirement accounts, and that's fine. As long as it's going toward building wealth, both investing and paying down the mortgage are good things to do. We don't need to get dogmatic about it.
# 6 Use windfalls to pay off mortgage
At some point in our life, most of us get a windfall of some kind. Perhaps it is an inheritance. Perhaps you just made a little more than you expected. Or spent a little less than you expected. Or decided you didn't want to own that wakeboat after all. Great! Send it in to the mortgage. Our big windfall was The White Coat Investor, LLC becoming financially successful. Yes, we spend a little extra. We give away a lot more (more than we spent in 2017). But most of what WCI made in 2016 that didn't go toward taxes, charity, or the individual 401(k)s went toward the mortgage in three big payments. And honestly, we could have done it about a year earlier than we did but chose to invest the money in taxable instead (and actually came out ahead for doing so.)
There you go. Mortgage acceleration. And you didn't even have to fuss with a HELOC. But if you want to do the magic version of mortgage acceleration, I don't think you're stupid. Just make sure you're aware of the risks, do what you can to mitigate them, avoid any significant fees, and stay disciplined. It may help a little.
What do you think? Do you do mortgage or equity acceleration? How did it work out for you? Do you feel that this technique is oversold? Why or why not? Comment below!