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Mortgages and Home Equity Loans
The benefits of homeownership for families, communities, and the nation are profound. It is through initiatives to further grow homeownership that we empower individuals and families by helping them build wealth and improve their lives.
Elizabeth Dole, former US Senator
Homeownership is more than a financial decision. Sure, those monthly payments represent forced savings, and of course you anticipate that over time your home will gain in value and produce a profit. But it is definitely more than that—much more.
Homeownership is a state of mind. A home is a place where you can enter, close the door, and know that all others must wait for an invitation. It’s a security blanket not often found with a rental agreement.
A home represents that one place on earth you can call your own, where your kids can put down their roots. It’s probably your only hope for a rent-free retirement in which no one will be able to take your home away from you.
Regardless of the way property values rise or fall, if you ever wonder whether you would be better off just renting a place so the landlord can take care of everything, remember this: Mortgage payments come to an end, but rent goes on forever. Homeownership is a good thing and would be out of reach for 99.99 percent of the people in this country were it not for the home mortgage.
From its inception, the home mortgage was designed so that people would pay it off just slightly ahead of retirement. To this day, it is reasonable to believe that thirty years is time enough to repay one’s home mortgage. Yes, one would think.
Homeownership versus Mortgage Ownership
Something changed in the seventy years between 1929, when Bill and Agnes McAulay refused to buy a car until their mortgage was paid in full, and 2011, when Jen and Travis Harris bought their first home. Not only are the Harrises stretching beyond reason simply to make their monthly mortgage payments on time, but they also hold absolutely no hope of living long enough to pay the mortgage off. What changed between then and now is our definition of homeownership.
To Bill and Agnes, owning their home meant owning their home. To Jen and Travis, owning their home means owning a mortgage on their home. Owning a home used to mean having a paid-in-full note and an unclouded title. It meant making significant sacrifices until the larger goal was reached. Now it means 360 payments, wondering if and when to refinance, unbelievable amounts of interest, and home equity lines of credit. Then, just when the equity starts building and the payments become not just manageable but comfortable, homeownership invariably means trading in one home for something bigger and better and picking up a fresh new batch of even larger payments.
The difference between owning a home and owning a mortgage depends on your way of thinking. If you start planning to reach the goal of owning your home outright, you can do it. But you’re going to have to take things into your own hands. You’re going to have to run the show.
Make Your Mortgage Work for You
Avoid Prepayment Penalties
Whenever you are shopping for a mortgage of any type, you want to make sure it is not subject to a prepayment penalty. In the 1970s and 1980s, it was not uncommon for a mortgage to carry some kind of stiff financial penalty if the borrower paid it off more quickly than originally prescribed. Thankfully, nowadays, prepayment penalties have mostly disappeared from home mortgages.
Prepay the Principal
The key to rapidly repaying your mortgage is to prepay the principal. Each month, you have a required payment. Much of that payment is interest; only a small amount is principal. That’s why you can make $896-monthly payments on a $125,000, 7.75 percent, thirty-year mortgage for two and a half years and still owe $122,000. You’ve paid more than $25,000 but reduced your debt by only $3,000. When you prepay the principal ahead of schedule—even by a little bit—it dramatically affects the eventual total cost of the mortgage. That’s because each month you pay interest on the remaining balance, which by all rights should be dropping, if only a little.
There are a couple of painless ways you can do this. The tactics will net you a tremendous amount of interest savings and bring your mortgage-free day much closer. However, beware of the following one that works but doesn’t make good sense.
Avoid Biweekly Payment Schemes
Years ago, a very smart person figured out that if you paid one-half of your mortgage every two weeks instead of the whole thing once a month, in a year’s time you would end up paying one extra payment. You see, if you make one payment a month, you make twelve in a year. But if you make one every other week, biweekly, you make twenty-six half payments in a year or the equivalent of thirteen monthly payments. So far, so good.
A problem arose, however, because mortgage companies were not set up to deal with half payments and a biweekly payment schedule—nor were they required to—the way that credit card companies are able to receive and process any amount at any time. Some banks would return the partial payments as “cannot be processed,” while others would just hold the half payment pending the arrival of enough money to make a full payment as required by the mortgage documents.
The desire of consumers to participate in this trendy, new, fast-pay method, combined with the entrepreneurial spirit, produced middleman companies who began selling the biweekly mortgage theory. Simply put, these companies would collect the half payments for a fee and then see that the equivalent of twenty-six half payments were sent to the customer’s mortgage holder each year.
Eventually, many lenders saw the demand for this alternative payment schedule and the money to be made by allowing customers to make biweekly payments. I imagine they didn’t like the idea of a middleman company collecting all that gravy. So with personalized letters that included the homeowners’ potential savings, some banks and mortgage companies tried to get customers to sign up for a special program that would convert the monthly payment schedule to a biweekly one, at a cost.
In the case of one major lender, there was a stipulation that the borrowers would allow the lender to deduct the equivalent of one-half payment from their checking account every two weeks for a one-time setup fee of $340 plus a $2.50 service charge for every withdrawal.
Even late-night television infomercials hawked biweekly conversion schemes but presented them as a complicated issue the typical homeowner was not qualified to handle.
Why did so many consumers fall for these biweekly servicing schemes? Marketing pitches can be powerful persuaders, and many people bought into the idea of simplicity, savings, and service. Becoming accountable to a middleman disciplined them to make those biweekly payments.
However, paying even one cent of your hard-earned money for the privilege of a special prepayment plan of any sort is a complete waste of money. Mortgage companies offering this for a fee should be ashamed of themselves.
The practice of mortgage prepaying is excellent, and here is a way you can do it yourself without having to seek permission or sign a contract. And you can change your mind at any time if you want to stop doing it. Again, without a penalty or permission.
Use a Do-It-Yourself Plan
First, divide your monthly mortgage payment by twelve. For example, a mortgage payment of $1,200 divided by twelve equals $100. Every month, send $100 along with your regular monthly payment of $1,200. As long as you are paying a full payment or more, the mortgage company has to accept and process the entire amount (the only exception would be if you have a prepayment penalty clause in your contract, which is rare). As a precautionary measure, I suggest you write a separate check for the additional amount with “principal prepayment” clearly written in the memo area of the check along with your account number. Now there will be no question as to your desire for the disposition of this extra amount.
If you fear you are not disciplined enough to make this additional partial payment each month, authorize your lender to automatically withdraw it from your checking account once a month. Virtually every lender will do an electronic transfer for free, but you have to ask.
With this alternative to the mortgage company’s biweekly payment schedule, you will pay the equivalent of thirteen monthly payments each year because you are paying an extra one at a rate of 1/12 each month. Sound familiar? That is exactly what you would be doing if you paid twenty-six biweekly payments in a year.
The power of principal prepayment never ceases to amaze me. Every dollar you invest into the prepayment of your mortgage is a dollar well invested, simply because it represents a guaranteed return on investment. No investment is as sure as a repaid debt.
If that $340 or $375 initial fee (whatever your mortgage company charges to convert your mortgage to a biweekly payment schedule) is something you really want to pay, pay it to yourself. Jump-start your new payment plan with an initial prepayment plus that amount. Every dime of it will go toward your home and not the bottom line of a middleman or mortgage company.
The tremendous savings of interest and hastening of one’s mortgage payoff date result from paying the equivalent of a thirteenth payment each year. Your mortgage company will not accept less than a full payment at any one time, but they will accept a payment that is greater than what you’ve agreed to pay each month. That is the key—and the reason you never want a mortgage with a prepayment penalty.
An important feature of this do-it-yourself mortgage prepayment plan is flexibility. Let’s say you find yourself in the unemployment line. Of course, you have your Contingency Fund and Freedom Account in place, so you will not panic. However, it might be in your best interest to pull back on every optional expense and carefully conserve your funds. If you have agreed to a formal biweekly conversion of your mortgage, you are pretty much stuck. You might be able to go back to monthly payments, but it will be a hassle, and it will undoubtedly result in an “unconversion” fee. Besides, this situation could be temporary, meaning you’d want the option to return to the highly beneficial biweekly plan at a later date.
Administering your own prepayment plan lets you retain the option of going back to monthly payments any time you want. You also retain the flexibility to prepay much more than just 1/12 of a payment each month. Say you receive a dividend payment or some other type of unexpected amount. You can choose to add that to your mortgage prepayment check. No amount is too small, and every cent of it will go toward your future. You could even calculate what the payment would be if your loan was amortized over fifteen years rather than thirty, increase your payments accordingly, and then reap all the benefits of a fifteen-year mortgage. Yet, you have the freedom to go back to the thirty-year schedule if necessary without seeking permission or going through any kind of conversion process.
Pay Down or Pay Ahead?
Some time ago, we refinanced our mortgage. The transaction closed in December with the first payment due in February. Rather than take a month off from making payments, we made an unscheduled payment in January to reduce the principal right off the bat. We were very careful to write “principal prepayment” on the check.
We received a detailed statement that correctly reflected the starting principal balance and showed that we had made an unscheduled payment, and it was credited in its entirety to reduce the principal.
The next day another statement arrived showing that the mortgage company had reversed the previous transaction and applied the total amount of that unscheduled payment to the February payment. Huh?! Why did they do that? The lady in customer service said someone must have assumed we wanted to “pay ahead” rather than “pay down.”
My explanation is just one word: interest. Applying that unscheduled payment to pay down the principal was not profitable for the lender. That’s a chunk of money they cannot collect interest on for the next fifteen years. Prepaying the principal saves huge amounts of interest and shortens the payback time. This one transaction will save us more than $4,000 in interest, and we’ll own our home three months sooner. On the other hand, applying it to the February payment put most of it into the lender’s pocket in the form of interest.
There are two common reasons that borrowers send extra money to their mortgage companies:
1. To pay down the principal. When you pay down the principal, your loan balance goes down. But you still have to make the next scheduled payment. Let’s say you make your regular mortgage payment in April plus three extra payments. You enclose a note that the additional payments are to pay down the principal balance. You will still have a payment due in May and June and July as scheduled.
2. To pay the account ahead. On the other hand, let’s assume you sent those three extra payments because you are going to Europe for the summer and want to pay all your bills in advance before you leave. In this scenario, you want to pay ahead. You’ll be back before the August payment is due.
3. If you are not clear how you want the extra funds handled, the lender might assume you want to pay down the principal balance. You head off on your trip assuming you’ve made your mortgage payments. Of course, you don’t get the late notices because you’re not around. You arrive home only to learn that your home is in foreclosure for failure to pay. You cannot assume the mortgage company will automatically pay your account ahead if you do not send clear instructions. Nor can you assume they will know to pay down the principal balance.
Some lenders will simply return additional payments if it is not clear how they are to be handled. Others automatically apply additional sums to future payments, defaulting to the lender’s benefit.
When you make prepayments on your mortgage, always enclose clear instructions. And make sure you also include your instructions on the check itself. But don’t leave it there. Follow up in a couple of weeks to make sure the transaction was handled per your instructions. And don’t be surprised if your lender is not easily persuaded to pay down. Unless you have a prepayment penalty clause in your mortgage (doubtful), you have every legal right to pay down your mortgage.
Refinancing Your Mortgage
Refinancing is tempting, particularly if you have a relatively high interest rate. Let’s say you could refinance and reduce the interest rate by a full 2 percent. Sounds like a great deal, right?
Maybe . . . but maybe not.
What about fees? There will be some, and even if they are rolled into the new loan, you need to know what they will be so you can make a wise assessment.
And now for the real test: How does the total payoff in your present situation compare with the total payoff of the refinance you are considering? Unless the interest on the refinance is significantly lower—and assuming that your goal is to own your home outright as soon as possible—it’s not worth it.
Let’s say you are twelve years into a thirty-year mortgage. Your original loan was $100,000 at 8.75 percent interest with monthly principal and interest payments of $787. You’ve made 144 of those babies—216 to go. If you stick with what you have, you still have $169,992 to pay (216 x $787) including the interest on the remaining principal ($85,400).
You look into refinancing. The lender says you can easily get a new thirty-year loan for $100,000 (or more if you want) at 6.75 percent interest with total fees of $3,000, which can be rolled into the principal (you would actually be borrowing $103,000). You can pay off the old mortgage, put about $10,000 in your pocket, and reduce your monthly payments by $118 to $668. Wow, it sounds pretty good. But how does that stack up?
With these terms, the refinance will be $668 x 360 months or $240,480. The refinance, even with lower payments, is going to cost you an additional $70,488 in the long run. The reason is simple. You’ve already paid back a good chunk of your current mortgage and you’ve reached a level where more of your monthly payment is going toward the principal. If you refinance to a new thirty-year mortgage, you start over with new big interest payments. Instead of owning your home in eighteen years, it’s going to be another thirty years. Bad deal.
There is a way you could make this refinance work for you. Borrow only the amount necessary to pay off the original mortgage ($85,400), pay the $3,000 in fees up-front, and choose a fifteen-year term. Let’s see how that changes the big picture.
You refinance $85,400 at 6.75 percent for fifteen years. Your new payback of $756 x 180 months equals $159,120. Add the $3,000 you paid up-front, and the total payback comes in at $162,120. Now that’s a good deal! Your payments are about $30 less each month, but more importantly, you reduce your total payback by over $7,500 and own your home three years sooner (in fifteen years instead of eighteen). Elect to keep making your old payments of $787 and you’ll pay it off in fourteen years and save another $3,200.
If you are considering a refinance, make sure you look at more than just the monthly payment. Find a good loan calculator with an amortization schedule. I have the perfect one in our members’ area at DebtProofLiving.com. You can plug in the information on your current mortgage to see where you are and your total payback at this point. Now you’re ready to consider a refinance—one that makes sense because it’s good for you!
Do your homework. Don’t rely on a loan broker to decide if refinancing is right for you. You have to understand that a broker (or even the loan officer at the bank) has something more than your best financial interests in mind. (You do know about commissions, right? Not that there is anything wrong with earning a commission, in the same way that there is nothing wrong with you looking out for your best interests!) If refinancing your mortgage will not improve your big picture—the total payback—don’t even think about it.
Home Equity Loans
Home equity loans are quite dangerous for this one big reason: You can lose your house for nonpayment.
If anyone had told the typical homeowner in the 1940s that second mortgages—then viewed as a major cause of human misery and financial ruin—would one day be a hip way to pay off credit card debt, send Junior to college, give Buffy the wedding of her dreams, or take the family on a Caribbean cruise, they would have been too stunned to respond. But that is exactly what has happened.
This type of loan got a spiffy new name in the 1980s—the home equity loan (HEL)—and it rocketed in popularity when it became the only game in town for the consumer seeking tax-deductible interest payments. Unfortunately, a second mortgage by any other name is still a second mortgage.
Locked up in your house is a beautiful pot of tax-free money, reachable only if you sell and move out. This money represents all the profits you’ve ever made on the homes you’ve owned.
A home equity loan does not unlock some big cash drawer in the sky with your name on it in the same way you would have that money at your disposal if you sold and moved. A home equity loan simply grants you the temporary use of these funds. Essentially, a HEL allows you to rent your equity, placing you under heavy-duty restrictions and requirements for the privilege.
Home equity deals come in two varieties: loans and lines. In either case, the homeowner is allowed to borrow up to 80 percent of the home’s current market value minus the balance on the mortgage.
Home Equity Loan
The home equity loan (HEL) is the traditional second mortgage. It generally comes with a fixed interest rate, and you get all the money in one lump sum to be repaid over five to fifteen years.
Home Equity Line of Credit
The home equity line of credit (HELOC) is the most dangerous of the two types of home equity loans. Typically, the line of credit is open-ended, meaning the amount of money available to you changes with the current market value of your home. As your equity increases, so does the amount of money you can borrow against it.
Once the loan is approved, the borrower receives the equivalent of a checkbook, not the proceeds of the loan. You simply (simplicity is one of the main problems with the line of credit) write a check to tap into the equity. You then pay interest on only the portion you have drawn out, not the entire amount available.
In theory, the HELOC sounds too good to be true—a way you can have your cake (own the property) and eat it too (spend the equity). In reality, it offers the same temptations as a dozen low-interest credit cards. Both closed- and open-ended home equity loans still let you ruin your financial life—just more slowly and, some financial-adviser types might argue, more intelligently than with credit cards.
I am generally opposed to both types of home equity loans but especially to the line-of-credit variety. First, it feeds the myth that the equity in your home is a liquid asset. Having those funds so readily available (essentially you are walking around with the sum total of your home’s equity in your pocket calling out to you the way money has a way of doing) makes you feel as if this is your money and you can spend it any way you please. A home equity line of credit brings new meaning to the idea of money burning a hole in your pocket.
If you resist, you might begin to fear that your spouse will find something to spend it on. You could quickly lose control and go through the entire wad in a week and a half. If you are the one who cannot rest as long as all that money is there to be spent, your spouse might be the one filled with paranoia.
When eventually you give in and spend it (and you will, trust me), even if it is for the most reasonable and noble cause, the vicious cycle will have begun. You make regular payments, but because nearly all of the payment goes to pay the interest, you don’t make a dent in the principal. Then when those unrelenting payments become a financial strain on what used to be your barely-making-ends-meet-every-month situation, the temptation to tap further into the equity will be there staring you in the face.
The equity in your home is one of your most precious assets. For most of us, it is the only appreciating asset we have now or possibly will ever have in the future. Borrowing against your home’s equity to pay down credit card balances, finance a fabulous family vacation, or purchase new furniture may not seem like a big deal if you are young and believe you have all kinds of time to prepare for retirement. But when you tap into your home’s equity, you are not only reducing its overall value but also severely retarding—and in the case of the line of credit, wiping out completely—that important feature called compounding growth. You are, in essence, killing the one financial asset that is actually growing.
Spending the equity in your home as quickly as it appears essentially eliminates the prospect of ever owning your home outright. It guarantees you will have mortgage payments or rent for the rest of your life. If you use that equity to pay for things early on in your life, it and all the offspring it should have reproduced are not going to be there when you deserve a rent-free retirement. When you reach into your home’s equity, you are, in fact, tearing a hole in your safety net. Never underestimate the worth of a rent-free retirement.
But It’s Deductible!
Unfortunately, many people are drawn to the concept of a home equity loan because the tax deductibility of the interest has a righteous ring to it. Let’s face it. This option qualifies as secured debt and shoves this kind of loan into the semi-intelligent category. But the benefit of tax-deductible interest is highly overrated.
Say you owe $1,000 on your home equity line of credit and your interest rate is 10 percent. If you pay the loan off in one year, you will pay $100 in interest. If you are in the 28 percent tax bracket, you will save $28 (28 percent of $100) at tax time if you itemize your deductions. So after you factor in your tax savings, the amount of interest you actually paid was just $72.
The point is that you still had to pay $72. Many equity borrowers assume that because the interest is tax deductible, the tax savings not only wipe out the effect of paying interest but also in some way reward them with cash back. Here’s another way to look at it. The after-tax interest rate on the 10 percent home equity line of credit was merely reduced to 7.2 percent. Big whoop.
Bottom line: You do not want to find clever ways to create tax deductions. Of course, you want to take all the deductions to which you are entitled if you have taxable income. But even the best deduction cannot erase the tax you must pay to create the deduction.
Let’s say you are in the 28 percent tax bracket. For each dollar of deduction you have, you receive a 28 cents reduction in the amount of money on which you must pay taxes. But here is the fact you dare not miss. You still had to pay out the $1 to the property tax collector, the banker, the mortgage lender.
If you are really bent on having lots of deductions, I’ll make you a deal. You send me all your dollars, and I promise to send back to you 50 cents for each and every one of them. You don’t even have to file a return or wait for April 15. What do you think about that deal? (I’ll be watching my mail.)
What Lenders Want You to Know
If you have eyes toward a home equity loan, the lender is going to do all he can to convince you that the line-of-credit type is better than the straight second-mortgage variety for the following reasons:
Flexibility. You can draw down as much or as little of the line as you want and pay interest on only the amount you actually use.
Easy access. You have either a checkbook or an ATM card that allows you access to the equity in your home.
Lower interest rate. Compared to the interest rate on a credit card account, the interest rate on a home equity line of credit is significantly lower. Because of its variable-rate feature, it is also lower than its cousin, the fixed-rate home equity loan.
What Lenders Don’t Want You to Think About
What the lender will fail to point out are the negatives that come packaged with a home equity line of credit:
The temptation. No matter how you slice it, a line of credit has “easy money” written all over it. Just knowing all the money is available brings decorators, travel agents, and car dealers out of the woodwork.
Lightweight repayment. Home equity lenders are particularly anxious for repayment to be done at a leisurely pace and over a long period of time. They don’t want you to repay too quickly or they lose their passive income stream.
Variable interest rate. This may seem like a nice feature when interest rates are low, but what happens when the cycle takes a turn and inflation kicks in? Remember, when the rate increases (and you must assume that it will), the entire amount you owe will be subject to the increased rate, not just the amount you withdraw in the future.
Annual fees. While a home equity loan does not have annual fees (all fees, if any, are part of the origination costs), a home equity line of credit is subject to an annual fee of $50 to $150. This fee is not included in the annual percentage rate and might not seem like such a big deal—until you multiply the fee by the number of years you will have that line available. Then it becomes a significant number.
Using a HEL
While home equity loans are not ideal (what kind of debt is?), I am not entirely opposed to them. However, their purpose is very limited.
Following the principles that set intelligent borrowing apart from that other kind of debt, the proceeds of a home equity loan should be used only to create or add to an appreciating asset. That means putting the funds right back into the home—to improve, renovate, or add to it. This way the home equity loan becomes a financial investment.
Troublesome Home Loans
The dramatic increase of home values in recent years has been met with an increase in “creative” home mortgage programs. Basically, these nontraditional loans are for people who are unable to qualify for a traditional mortgage with its more reasonable terms.
Many states have instituted subsidized home loan programs designed specifically for first-time buyers. While many are good programs, there are at least two types of home mortgages that should be avoided.
Interest Only
With this type of loan, borrowers pay only the interest during the first years of the loan (usually five years). The pitch from the loan salesperson is that the property will appreciate dramatically. By the time five years have passed, the borrowers will be in a higher income bracket, and at that time they can simply refinance their very valuable home into a fixed-rate loan. Nice theory. However, the risks far outweigh the positives.
Unpredictable market. Of course, during good times it appears that home values will only increase. But real estate values rise and fall. When you have no equity in your home, if the values drop, you’re stuck with a home you cannot refinance and you cannot sell.
Rising interest rates. No one knows where interest rates will be in five years. They could be double the current rate. But if you have an interest-only loan, you will have no choice. You will be forced to refinance into a loan at the then-prevailing rates. And that could be devastating to your financial situation.
In over their heads. In most cases, the purpose of an interest-only mortgage is to allow borrowers to buy a home they could not otherwise afford. That is very dangerous. An 80 percent mortgage with a 20 percent down payment represents a safety net. You would be better advised to buy a home you can afford and for which you have a down payment than to get in over your head.
125 Percent
Following the real estate crash of 2007–8, subprime loans became the bane of the home lending industry. But slowly, the low to no down payment loans have come back, as have the worst of the worst—the 125 percent mortgage. Perhaps you have seen the compelling commercials on late-night television offering loans that lend you more than the full market value of your home. The problems with such a ridiculous loan are many.
Fees. Finding out the details of these loans is not easy. I’ve called as both an investigator and a potential customer. I could not get any salesperson to state the interest rate or the fees involved. They will deal with you only after you have filled out a loan application and given them permission to pull your credit report. Therefore, I had to get this information from people who fell for the pitch and now live to regret it.
Interest rates on these loans are outrageous, often 5 to 10 percentage points higher than the going rate. And up-front fees can be as high as 15 percent of the loan amount.
Prepayment penalty. These loans almost always carry a stiff prepayment penalty. If you attempt to accelerate payment of the amount borrowed or pay the loan in full through refinancing or selling, you are hit with a huge penalty.
In my opinion, these companies have just one thing in mind: They want your property. The intention is to take advantage of a miserable situation (these loans appeal only to those who can least afford them), fleece you of every dime up-front, grab all the interest they can from you in the beginning while you are still hanging on by your fingernails, and then simply hang a foreclosure notice on your front door when you fall behind.