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The world of credit

National Mortgage Professional
Mar 06, 2008

The HELOC: Your most powerful financial toolMike Smeladebt, consolidate credit, Home Equity Line of Credit, stagnant money, active money Most people think of their Home Equity Line of Credit (HELOC) as another debt—a lending vehicle most often used to consolidate credit cards, help pay for college or just to have in case you need to borrow equity from your home for emergency situations. What most people (and even most mortgage, banking and investment professionals) don't know is that an equity line of credit has the rules and features to actually become one of your most powerful financial assets! To truly understand how a loan can become a powerful financial asset, we must understand three very important issues: stagnant money versus active money, the differences between closed-end loans and open-end loans, and the concept of interest cancellation. Stagnant money versus active money From the time of our youth, we were always taught that saving money was good. Most of us, at one time in our lives, were given a piggy bank as a place we could begin to save our coins and dollars. As we got older, Mom and Dad took us to our local bank to deposit our piggy bank and birthday money into an interest-bearing savings account. The bank would faithfully hold our hard-earned money and actually pay us interest so we could start accumulating wealth. When we reached our teen years and got our first jobs, we went back to our trusted bank and opened our first checking accounts. Checking accounts provided more and easier ways to access and deposit our money. If we were lucky, our bank even provided free checking. If we weren't so lucky, our bank actually charged us fees for them to hold our money. In either case, our checking account rarely paid us any interest, while the bank used our money to make money for its shareholders and pay for all the signs on the top of every city's tallest buildings. And so our education into the American banking system began. To this day, most Americans maintain a checking account and some form of savings and/or high-yield money market account. Of course we do. That's the way weve always been taught (by our parents, our school system, the banks and the media), and that's the "normal" way to bank. Let's think about this for a minute. We bust our butts working 40- to 60-plus hours every week to earn our money. We then take our precious reward and deposit (or direct deposit) it into our checking account. There it sits, waiting for us to do something with it. Our money makes us little or no interest. But we do have access to our funds through checks, online banking, automatic bill pay and ATM/debit cards. We have relatively easy access to our money, but we get virtually no financial benefit from our checking account. The same is true with a savings or money market account (unless you really consider 0.5 percent to five percent annual yield a financial benefit!). And, in many cases, we actually get charged fees if our balance drops below a certain level, we write too many checks or simply because them with the gold make the rules. In reality, our money provides us no financial benefit. It is truly stagnant money, at least for us. On the other hand, our trusted bank utilizes our money, along with the money of all our neighbors, and lends it out, invests it or securitizes it to make lots of money for the bank! So really, our money isn't stagnant. It's just stagnant for us. But what can we do? We need easy access to our money, and most other financial vehicles that actually pay a decent rate of return don't allow us the flexibility to access our funds without charging exorbitant fees and/or substantial penalties for early withdrawal. Before we answer that dilemma, let's look at another issue—closed-end versus open-end loans. Closed-end versus open-end loans Closed-end and open-end loans have very different features and rules that can lead to very different results. Closed-end loans (mortgage loans and most installment loans) are like a one-way street. The lender will only apply payments once a month and only if the minimum agreed-upon payment is made. If your mortgage payment is $1,000 per month and you only send $999.99, your lender will not accept and apply your payment. At the same time, if you make your regular monthly payment on the first of the month and then send another $500 halfway through the month, the bank will gladly accept your payment, put it in one of their accounts and credit your money to your mortgage when they receive your next scheduled payment at the first of next month. Your extra $500 payment will not benefit you the day it is received by the bank. Closed-end loans also don't allow you to access the equity you have built up over time. If you originally borrowed $200,000 on your home loan, have religiously paid your mortgage on time for 10-plus years and need to borrow back $50,000 because you lost your job, the rules of your closed-end mortgage still wouldn't allow you to access these funds (your equity). Furthermore, the interest on a closed-end amortized loan is front-loaded in the lender's favor. Interest is calculated by multiplying the monthly ending balance by your interest rate. If you originally borrowed $200,000 at six percent interest on a 30-year fixed-rate loan, your payments are contracted at $1,199.10 for 360 months. Of your first payment, $1,000 is applied to interest (83 percent of your payment) and only $199.10 (17 percent of your payment) is applied to pay down your principal. Such a deal! In month number two; your principal contribution grows by a whopping $1. Over the life of your 30-year mortgage, you will pay a total of $231,682 in interest charges to your lender in addition to the $200,000 you originally borrowed. That brings your total payments to $431,682. Mortgage fun fact #1 If you purchased your home in 1986 and took out a 30-year fixed-rate mortgage at six percent, here is what you would have accomplished over 21 years: Balance at the end of 21 years = $99,877.76 (Yes, you are finally at your halfway point.) Total principal paid over 21 years = $100,122.22 Total interest paid over 21 years = $202,055.96 Total of payments over 21 years = $302,173.18 Total interest you will pay over the next nine years = $29,626.08 (Now do you think your interest wasn't front-loaded in the bank's favor?) Percentage of interest paid to total of payments: $202,055.96/$302,173.18 = 66.86 percent After 21 years of faithfully paying on your mortgage, 66.86 percent of your hard-earned dollars went to your lender. Mortgage fun fact #2 The root meaning of the word "amortization" is "amort," meaning death, and "ization," meaning slow and drawn out. So "amortization" means a slow, drawn-out death. Interesting, isn't it? The root meaning of "mortgage" combines "mort," or death, and "gage," or "pledge." A mortgage, therefore, is a "death pledge." Getting back to our lesson, open-end loans have very different rules that can lead us to very different financial results. Open-end loans can be thought of as a two-way street. Payments can be made multiple times throughout the month, and the bank must accept and apply these payments, thereby forcing a reduction in the balance owed (and interest charged!). You can also draw money out of an open-end loan multiple times throughout the month, turning this type of loan into more of a liquid type of account. Open-end loans also calculate interest differently than closed-end loans. Remember, the formula for calculating interest on a closed-end loan is the monthly ending balance times interest rate equals payment. Interest on an open-end loan is calculated on the average daily balance. Creating an interest cancellation account Using the rules of an open-end loan, like a typical HELOC, you can use your HELOC to create an interest cancellation account, whereby you borrow the bank's money for a period of time and pay very little, if any, interest (regardless of the interest rate on the loan). Let's imagine you are a mortgage loan officer paid on commission (like that's a stretch!). Business is a little off, bills are due, and you don't have a commission check coming until the 15th of the month. Because life continues with or without your income, you buy $100 of groceries on the first day of the month, using a debit card or access check from your HELOC, which carries an interest rate of 10 percent. Two days later, you treat your family to a nice dinner and access another $200 from your HELOC. Later that week, you access another $700 from your HELOC to pay for your daughters braces. Finally, on the 12th of the month, you write a check from your HELOC (at 10 percent) to make your $1,199.10 mortgage payment (at six percent). Over the first half of the month, you now owe $2,199.10 on your equity line. Finally, you receive your commission check on the 15th of the month of $3,000. Being the financially astute professional you are, you pay off the balance on your equity line. The balance on your HELOC remains at zero for the remainder of the month. When your HELOC statement comes at the beginning of the following month, here's what you'll see (the math may not be accurate, but we're trying to get a concept across here). Debits: July 1: $100.00 (groceries) July 3: $200.00 (dinner) July 7: $700.00 (braces) July 12: $1,199.10 (mortgage) Credits: July 15—$2,199.10 Balance July 15: $0.00 Average daily balance for July (approximately): $1,000.00 Interest charges at 10 percent = $1,000.00 x 10 percent/12 months = $8.33 So what did you accomplish? The rules of your open-end equity line of credit enabled you to borrow money to feed your family, pay your daughter's orthodontist and make your mortgage payment. By paying the balance off on the 15th of the month, you were able to "cancel" the interest you would have been charged for the entire month. Even at a 10 percent interest rate, you only paid $8.33 based on the average daily balance. Compare that to if you would have waited until you received your paycheck and then made your mortgage payment. Your mortgage payment would have been received late, kicking in a five percent late charge. $1199.10 x 0.05 = $59.96. By using the rules of your open-end HELOC, you saved yourself quite of bit of money, even though you "borrowed" money at 10 percent to make your six percent mortgage payment. (By the way, $1199.10 x 10 percent/12 months = $9.99. You actually borrowed $1,000 more from your HELOC and only paid $8.33 for the month. That means your actual cost of borrowing the money was less than your 10 percent rate of interest!) Combining the concepts Hold onto your hats! Now that your mind is open to some different ideas (like a parachute, your mind only works when it's open), let's see how we can combine these concepts to now turn your "high interest rate" equity line of credit into a very powerful financial tool. 1. We want our money working for us and not the bank (active versus stagnant money). 2. The open-end HELOC has rules that can be used to our advantage. 3. These rules can help us use our HELOC as an interest cancellation account, using the bank's money to our benefit, while paying back far less actual interest. What if? 1. What if you turned your equity line of credit into your primary checking account, depositing your paychecks into your HELOC and paying your bills from it as well? We saw from our example above how we actually used the bank's money quite effectively while paying very little interest on the money. 2. What if you could supercharge that concept and use the bank's money, virtually interest free, to invest money or, better yet, help pay off your primary mortgage (remember your horrible results after 21 years)? Supercharging your equity line Did you realize one $5,000 principal contribution made at the beginning of your $200,000, six percent 30-year mortgage would affect the following changes to your contracted amortized mortgage? Number of payments saved: 23 Total of payments saved: $1199.10 x 23 = $27,579.30 Interest saved: $23,437.60 Total effect of making one $5,000.00 principal contribution at the beginning of a 30-year mortgage = $51,016.90 So, what if you borrowed the $5,000 from your equity line of credit (at 10 percent interest)? In order to envision this, we'll need a few more constants for our example: Net monthly income: $5,000.00 paid at the first of the month (not a typical pay, but it works for our example) Monthly expenses: $4,000.00 (all payments, plus living expenses) Monthly discretionary income: $1,000.00 (monies left at the end of the month) By using your equity line as your primary checking account, let's look at what would happen. Month one $5,000.00—Applied as principal payment to mortgage (effected a $23,437 interest saving) $4,000.00—Living expenses $9,000.00—New balance $5,000.00—Deposit paycheck $4,000.00—Balance for remainder of month (let's assume this becomes the average daily balance) Net effect month one: Interest charges at 10 percent on $4,000 = $33.33. We effected a $23,437 interest savings and reduced our mortgage by one year and 11 months for the open-end interest charges of $33.33. Month two $4,033.33—Beginning balance $4,000.00—Living expenses $8,033.33—New balance $5,000.00—Deposit paycheck $3,033.33—Balance for remainder of month (average daily balance) Net effect month two: Interest charges at 10 percent on $3,033.33 = $25.28 Month three $3,058.61—Beginning balance $4,000.00—Living expenses $7,058.61—New balance $5,000.00—Deposit paycheck $2,058.61—Balance for remainder of month (average daily balance) Net effect month three: Interest charges at 10 percent on $2,058.61 = $17.16 Month four $2,075.77—Beginning balance $4,000.00—Living expenses $6,075.77—New balance $5,000.00—Deposit paycheck $1,075.77—Balance for remainder of month (average daily balance) Net effect month four: Interest charges at 10 percent on $1,075.77 = $8.96 Month five $1,084.73—Beginning balance $4,000.00—Living expenses $5,084.73—New balance $5,000.00—Deposit paycheck $84.73—Balance for remainder of month (average daily balance) Net effect month five: Interest charges at 10 percent on $84.73 = $0.71 After five months, we have our HELOC balance virtually back to zero. Our total accumulated open-end interest charges have been $85.44. Now we run into a problem. Beginning with month six, we won't owe enough on our equity line to deposit our $5,000 paycheck. Month six $85.44—Beginning balance $4,000.00—Living expenses $4,085.44—New Balance $5,000.00—Deposit paycheck $914.56—Balance for remainder of month (average daily balance) Problem: We can't have a positive balance in our HELOC. Since it is a loan, we can't accumulate money. Solution: Borrow more money against your equity line (say another $5,000). Apply that money as another lump-sum principal reduction and crank the HELOC machine back up again. Another $5,000 principal contribution to your primary mortgage will cancel more interest on the back end of your loan, reduce your payoff time even further and effect a greater principal contribution to every one of your future mortgage payments. All this will lead to a positive compounding affect in your favor, helping you pay down your closed-end, front-loaded, amortized loan much more rapidly. Over the course of a full year and into the future, you will pay some interest on your equity line. Consult your tax advisor, as the interest may be tax deductible. Even though your equity line interest rate will be higher than your primary mortgage, the actual cost of borrowing the money from an equity line will be significantly lower. Because of the rules of your closed-end primary mortgage, you will affect a massive reduction in interest payments and shorten the term of your mortgage. In essence, you will borrow money (from the bank!) at a higher interest rate (but far less actual interest cost) to dramatically pay off a lower-interest-rate loan (but far greater front-loaded interest cost). Best of all, you end up paying down your primary mortgage without affecting your monthly budget. Hopefully you can see how by thinking differently and using existing banking rules your equity line of credit can truly become a powerful financial tool instead of just another high-interest-rate debt. Once you understand these powerful concepts, you can help produce tremendous financial benefits for your family and secure the financial futures of your many clients. The concept of using an open-end loan as your primary checking account has been used successfully in Australia and parts of Europe for many years. With the U.S. savings rate below zero percent and many real estate markets declining throughout our country, the time for us to affect some positive changes in our financial futures and the financial future of our country is now. A few cautions and opportunities Using your equity line as your primary checking account and borrowing sums at certain times to pay down your primary mortgage will not work if you consistently spend more money than you make (duh!). You need some amount of fiscal responsibility and discretionary income available to help pay down your equity line. Also, deciding how much money to borrow (and when) to pay down your primary mortgage can be a challenge. Borrowing too much against your HELOC may lead to increased interest charges (borrowing too much at a higher interest rate to pay off lower interest-rate debt). Borrowing too little may not lead to your greatest savings advantage. How do you effectively coordinate your income, expenses, first mortgage and equity line? You can certainly try to do it on your own. Some math and computer geniuses may even be able to devise some sort of spreadsheet. There are also financial software programs available that can help you coordinate your income, expenses, first mortgage and equity line. The bottom line is that each of us as mortgage professionals and consumers should learn to utilize the rules and tools available through our industry to affect a positive financial future for our families and the lives of our clients. Let's go help families take better control of their finances and become debt free! Mike Smela is a vice president, recruiter and national mentor for Carteret Mortgage Corporation and the founder of Physician Lender.com. He can be reached at (248) 816-3289 or e-mail mikesmela@physicianlender.com.
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