www.shredmymortgage.com
www.truthinequity.com
Full disclosure: I am about to embark on this strategy myself for student loan repayment. I have not personally done this yet but the math adds up FOR ME, maybe not you...
I confess I haven’t read all of the posts, but there may be a way to pay off the mortgage at least a little sooner without increasing your monthly payment:
http://www.shredmymortgage.com
http://www.truthinequity.com
Full disclosure: I am about to embark on this strategy myself for student loan repayment. I have not personally done this yet but the math adds up FOR ME, maybe not you…
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Okay, I'll try my best at explaining it so please forgive me if I am being unclear.
For one, it doesn't matter what the interest rate is so much as it matters how much money you actually pay in interest. I'd rather have a loan at 50% APR on a $1 loan (50 cents per year) than a 0.01% loan on $100k ($10 per year). So the interest rate is only one piece; it is the average daily balance on the loan that is a very important second.
You asked what leveraging your income means, and I think it would be most helpful to give a more realistic example with numbers. Before I get into the example, I want to explain to anyone who may not know the difference between a line of credit and a traditional loan. With a traditional loan, you take the money and then have an agreed upon interest rate, and the loan is amortized into a fixed monthly payment. Some goes to interest (maybe most, depending on how big the loan and how early you are in the amortization schedule) and the rest to principal. Once you make the payment, you can't get that money back.
With a line of credit, you can take money out of the line of credit to use for expenses (like paying your credit card bill). Interest is also charged on the average daily balance of the loan, and you generally do have a minimum monthly payment, but unlike the traditional loan, you can take money back out of the line again when/if you need to. The ability to put money in and take money out at will is what makes a line of credit so powerful for high income professionals who also have a lot of debt to pay off such as a mortgage, or in my case, student loans.
There are two types of lines of credit that I'm aware of: a home-equity LOC (HELOC) and a personal LOC (PLOC). The former is secured and typically a lower interest rate; the latter is unsecured and typically a higher interest rate. Currently, most HELOCs I've seen are around 5%. Mine has an introductory rate of 2.74% for the first year.
Okay, on to the example, let's say person A has a traditional loan of $100,000. Mortgage, student loans whatever. The loan is at 5% APR. He makes $10,000 per month, expenses are $5,000. He has an emergency fund, so the rest of his income goes to the loan every month, regardless of the term of the loan. He will have that loan paid off in 21 months and pay $4,632 in interest.
Person B transfers the same loan to a HELOC, also at 5% APR. He gets paid on the 1st. He puts the entire $10,000 paycheck into the line of credit. Now the interest being accumulated is on $90,000 instead of the full $100,000. During the month, he puts his expenses all on a credit card which payment is due on the 30th. On that day, the daily balance bumps back up to $95000. To make the math easier, let's say essentially for the entire month the average daily balance was $90,000 (ignoring the fact that on the last 1-2 days of the month the daily balance was higher due to the credit card payment). Then on the 1st he gets paid again. So, same loan amount, same expenses. In this example, person B will also pay his loan off in 21 months, but will pay only $3751 in interest, saving $881 in interest over less than two years. Not much difference in this scenario, but person B doesn't necessarily need that emergency fund because if an emergency does come up he can actually just borrow the money out of the line of credit, leaving him free to invest most or all of the emergency fund.
Let's try this on something more mortgage like. It get's more complicated but more powerful. Warning: you need to know how to create amortization schedules to double check my work.
Let's make these two physicians put $100k down on a $400k home, making $200k with a take home of around $11k monthly after taxes. Expenses are $8000 monthly (including mortgage). Physician A has a traditional 30 year mortgage, meaning his monthly payment is $1610.46. He makes no advance payments. At the end of 30 years, he will pay $279,767 in interest, or 93.3% of the total mortgage value. That interest rates seems pretty crappy now, doesn’t it?
Physician B gets the same house and same mortgage terms. However, he gets a $40,000 HELOC (90% loan to value, which is what most banks will give up to) immediately after purchase. He puts all that down on the mortgage principal. Now the mortgage is $260,000. He has advanced his mortgage amortization by 91 months (7.6 years), saving $106,764 in interest. If he makes $11k monthly with $8k expenses, he can get the HELOC paid down in 14 months, costing $662 in interest. Then he dumps the HELOC $40k back into the mortgage again, saving 61 months (5 years) and $60,317 in interest. He builds the HELOC back up, again costing 14 months and $662 in interest, and does that until the mortgage is paid off. The end result: home paid for in ~80 months. HELOC costs: ~$4,634. Mortgage costs: ~$49,593. Savings: ~$230,000 in interest. (I could be off by a couple thousand or a couple months…new to these calculations).
Now, what happens if you are Physician C and don’t use the HELOC and just pay all your extra income on the mortgage? You pay the mortgage off in 130 months, paying $88,887 in interest. So “leveraging” your income can become quite powerful, saving ~50 months and ~$34,000.
I have attached my spreadsheet I used to come up with the mortgage example. It’s probably hard to follow, and I apologize, but it’s hard to keep the math neat. I can clean things up if requested and answer more questions if requested.
If you read through all that, I thank you because it took a long time to come up with!
Okay, I’ve read through all the post. And I’m trying to keep up with everything but admit I don’t understand everything yet. I’m only 8 months into financial education and still in the negative net worth phase…
I too have read the statistic of the average duration of owning a home is 8 years. On a 30 year amortization, by year 8 in the above example you’ve only put $42,441 extra equity into the home when you sell. You’ve put $112,163 toward interest, even if that interest is tax deductible it’s significant. If you could pay the home off in < 8 years as in the above example, you could sell it and buy another house likely outright. That “feels” like a good thing to me, even if your strategy works objectively better (but I don’t see it yet).
I used the FV function and was surprised to see that if you took the extra $3,000 in the above example and invested it at 10% interest over 30 years, the total amount would be $493,000, versus in my example focusing on the house payment for 8 years and then investing the mortgage amount plus $3,000 into a similar investment would yield only $328,000. So my way I’m out $165,000. So I see that point. Compounding is pretty amazing.
However, I guess my final thought would be that if you can pay the house off in 8 years, you could then increase your HELOC to $200,000 if you wanted to and invest it all. Over 22 years at 10%, that would yield $1.6 million and cost you $30,000 in interest while paying off the HELOC over another 77 months.
I know that 10% is probably way too optimistic but it still seems like paying the home off sooner and taking a HELOC on the home of whatever amount your comfortable with and investing it wisely is not a terrible idea.
At this stage in my life, with my negative net worth and limited financial knowledge, I value the security of owning a home outright I guess.
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Very well put Zaphod.
I would absolutely agree and add that physicians by nature are risk averse and would pay down debt
I am with you. I leverage debt.
Great post.
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Agree. As humans we are wired to over react and place too much emphasis on low risk events and not put enough on real risks, part of why we see the problems in health we do. The trick is to educate yourself about it and whats most likely. Doctors are even more so as unfortunately due to training our natural confirmation bias is actually increased as a way to come to the most likely conclusion. Its bad when this spills into the rest of your life, makes it harder to be rational.
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