There is a big misconception in the financial world and among consumers today that all interest is the same: that, for example, a 6 percent mortgage is the same as a 6 percent line of credit. That’s not true, because the type of interest you are paying and how it is calculated are just as important.
Most U.S. mortgages are financed with fully amortizing loans. This means that a monthly payment to pay off the loan is based on the interest rate, the amount and the term. For example, if you borrow $200,000 using this kind of loan, your payment based on a 6 percent rate and 30-year amortization schedule is $1,075.
You may have heard that just one extra payment a year toward the principal of such a loan will pay it off about 10 years sooner. Homeowners have many reasons not to do this. They don’t want to tie up that extra $1,075 in their house. They receive no immediate benefit. They would rather keep their $1,075. They want to spend it on something they probably don’t need and won’t want three months after they buy it. They reason that they will sell their home in eight years anyway, so it doesn’t matter. Or they believe interest rates are so low now that they should borrow as much as they can, and invest all of their money rather than paying down debt, because they will come out ahead that way.
That last argument is seriously flawed.
Reduce the Finance Charge
In home equity lines of credit — also called HELOCs — the interest rate is less important than the finance charge. Finance charges on lines of credit are figured on average daily balance for the month. For example, when the 30-day finance period closes, your bank calculates that you had an average daily balance of $50,000 and the interest was 6 percent, so you will pay $8.22 per day in finance charges. Your interest charges for the month total $247, so your total payment might be around $325 because the bank will also require some money toward the principal. Simple enough, right?
What happens if on the first day you pay $5,000 on the principal? Your balance is now $45,000, so your 6 percent rate now produces a finance charge of $7.40 per day or $222 for the month. You consider that $5,000 as a pay-down, but your bank considers that $5,000 as your payment for the month.
Where do we get the $5,000? How about if you used your paycheck? Too many Americans let their pay sit in checking accounts until they pay bills. Why let that money sit there earning zero (or very little) interest? Let that income sit in your revolving line of credit to reduce or cancel finance charges.
If the line of credit is properly set up, would you be able to access your funds by writing a check? Absolutely! Would you have immediate access to any extra loan pay-downs, such as the $5,000 in the example above? Absolutely! Would the time that your money sat inside the line of credit affect your finance charge to your favor? Absolutely!
Make Every Penny Count
Let’s go back to that example. You pay down $5,000 on your line of credit — but only for 20 days, until you need most of the money to pay bills. The money then gets withdrawn (borrowed again). Your average daily balance and finance charge have been reduced. This is making every penny count by earning or canceling interest every day.
The next step is to leave some discretionary income in the line of credit. Over time, your line of credit will fall dramatically and seemingly without effort. When you balance goes down to $40,000 and all the bills are paid for the month, you can borrow $10,000 from the line of credit and send it to your first mortgage as loan pay-down? You should and do it as often as possible.
You are systematically transferring your debt from front-end-loaded amortized debt to average daily balance debt. Every time you do this, your will increase the port of your regular mortgage payment that goes towards the principal and reduce how much goes toward interest. In this was, you can use the principles of interest cancellation (and some of your discretionary income) to pay off mortgages, cars and any other amortized loan in a fraction of the scheduled time. I’ve had many clients take almost-new 30-year mortgages, and using this program, put themselves on pace to pay them off in six to 12 years without it affecting their lifestyle.
Many Australians open big lines of credit to buy their homes and pay their mortgages off in a fraction of the time it takes most Americans.