It seems appropriate that I’ve reserved Thursdays to discuss the Money Merge Account and Thanksgiving is celebrated on Thursday. I know, I’m a bit predictable. Here it comes. MMA is a turkey. Happy Turkey Day.
I believe the Turkey is saying “the factorial math will save you a bundle, you can’t do this one your own!”.
Joe
When I was discussing Mortgage interest, I received a few emails asking to to spell out a bit more clearly how regular mortgages calculate interest vs how home equity lines of credit (HELOCs) calculate. Fair enough.
One disclaimer; before you act on my explanation here, confirm with your bank that your mortgage is as I describe. I share here my understanding and experience, but it’s certainly possible that your bank follows different rules.
A standard fixed mortgage with a due date of the first of each month will often have a grace period allowing payments up to the 10th or even the 15th of the month with no late fee and no extra interest accrued to the account. On a monthly payment of $1200, this extra 15 days float is worth about $36 assuming a 6% mortgage. You see, it’s money available 15 days per month or half the time, so half of $72 is $36. Not a huge sum, but if your bank has a grace period this generous, you can save a bit by taking advantage. Just as the bank may have a grace period, they will not offer you any savings by paying a week, two weeks, or even a full month early unless you specifically note the extra funds are to go to principal. In that case the next regular payment is still due on the upcoming first of the month.
A HELOC, on the other hand, charges interest to your account based on average daily balance. I know of no bank that will lend you money from the 1st to the 29th but if your balance is $0 on the 30th will charge you no interest. That suggestion is absurd, and repeated by people who are either very confused, or those trying to perpetuate a lie. Just because someone in the mortgage business believes he “borrowed the bank’s money interest free” doesn’t make it so. In fact, it undermines his credibility as well as the agent who uses such nonsense as “proof” and a testimonial. To be clear, whatever the rate is on your HELOC is multiplied by your balance at each day’s end and accumulated over the course of the month. If you borrow money on the 1st and pay it in full on the 3rd, that’s 2 days interest. If you run a small balance, this may just amount to pennies, but you are still being charged this interest each day.
MMA agents will confuse you with this even more easily than they confused this mortgage broker. They will suggest that there’s some magic to the the way HELOCs calculate interest vs how the standard mortgage calculates. There may very well be a few dollars savings to be captured, but that’s nothing compared to the $1000 you are prompted to pay each month from your own money. Don’t be confused into believing the software creates this savings. In fact, when you ask an agent to run an analysis using as little discretionary income as possible, you’ll find they offer you numbers that easily show the lack of value of this software. I’ll discuss their analysis further in a couple weeks.
Joe
If you have not yet done so, please read part 1, part 2, part 3, part 4, part 5, part 6, part 7, part 8, and part 9 of this series first, then read on.
I received a number of emails after part 5 where I mentioned the HELOC use, but didn’t explain what MMAs claims are regarding this process. So let’s review the claims of the MMA agents.
While an honest agent will acknowledge that the prepayment of principal mostly comes from the paychecks of the home owner, many have managed to exaggerate the saving due to HELOC use and suggest that one can’t do this on their own. In the classic example, the client has $5000 worth of income, and $4000 in expenses. You’d imagine that during the course of an average month the client will see that their (0%) average monthly balance is as much as $3000, even though they may end the month with little sitting in checking. So what MMA claims to do is to borrow the difference ($2000) from the HELOC, depositing $5000 toward mortgage principal, and borrowing back from the HELOC as expenses arise. In theory, if the HELOC rate were the same at the interest rate on one’s mortgage, this strategy would create a rate of return on that average $3000 equal to the rate on the mortgage. But as I reviewed in my part 5 in this series, even if we assume the entire month’s income is available the whole month, the best we’d see from the HELOC use is $5000 x 6%, or about $300 per year. If we fall back to the $3000 average balance, the savings is just $180/yr. Not bad, right? But when we take the cost of MMA ($3500) and pay it off over the 10.4 year example, we find the annual expense to be $453/yr. For MMA to just break even would require an average checking balance (which for some odd reason is earning 0%) of $7,550. This would imply a monthly net income closer to $10,000 at a minimum. Nowhere else are these numbers discussed or disclosed. The latest version of MMA (V4) does take the claims to a higher level. The new software assumes another month’s float from the client using a credit card to charge every expense for the month, and use that float to pay toward the mortgage. Don’t fall for that either.
The agents promoting MMA manage to combine their own lack of understanding with a series of outrageous claims and take advantage of the average Joe not understanding how compound interest works. So far, in this series I have shown you the maximum amount you can possibly ring out of your ‘idle’ cash, and have shown how it’s a tiny fraction (a thousand dollars, if that much, vs the $164,000 in interest one can save) of the savings simply created by prepaying your mortgage with that same $1000/mo free cash flow.
Joe
If you have not yet done so, please read part 1, part 2, part 3, part 4, part 5, part 6, part 7, and part 8 of this series first, then read on.
Last week, we started to discuss how mortgages work, showing the effect of paying a small extra principal payment along with your mortgage. Now, I’d like to offer at a glance, the require payments for a $200K, 6% fixed rate mortgage for different lengths of time:
We can see above that a small increase in monthly payments, $89, will drop the payoff from 30 years down to 25. Another $144, and it would drop down to 20 years. Again, this is simple math, not rocket science. MMA examples suggest that an additional $1000 per month and MMA will have you pay your mortgage off in 10.4 years. Look above, a 10 year mortgage has a payment $1020 higher than the 30 year mortgage. If you wish to pay your mortgage off in this amount of time, regular prepayments will achieve the same results as any expensive software.
It’s important to note that shorter term mortgages always offer a lower rate that the longer term. Typically, a 15 year will be 1/2% lower than a 30 year mortgage. What does that mean to you? It suggests that if you are aggressively paying ahead you will find that when you show you are at the 12-13 year mark (i.e. about 17-18 years left) you may be able to refinance to a 15 year loan and see only a slight increase in required payments.
More important, this implies that if you have the ability to throw all this money at the mortgage, why not consider the shorter term in the first place? This is something the agents never seem to discuss, perhaps because they don’t understand how mortgages work.
Next, let me offer another snippet of spreadsheet, this one similar to last week’s but with some additional details:
What I added above were two additional columns, one to show remaining months until the mortgage is paid off, and next, the amount of interest that you will not pay due to prepayments. You can see, the first extra payment of $1000 reduces your mortgage by an extra 5 months, so after that first payment you have only 354 payments left (plus a bit). After those first two prepayments, you are now a year into your loan, with just 29 years to go. This is from a larger spreadsheet I offer my readers, one in which you can enter your mortgage amount and interest rate. You can then track your own progress on your loan and see what impact any prepayments would have on your payoff time.
Note: The spreadsheet I referenced is available upon request only. At this point, I still prefer to track how many times I’ve sent it out, and follow up with the people who have requested it, asking for comments and questions. Please add a comment if you wish to receive a copy.
Next week, more on the HELOC shuffle.
Joe
If you have not yet done so, please read part 1, part 2, part 3, part 4, part 5, part 6, and part 7 of this series first, then read on.
I think we are at the point in this series where I should take a step back and offer a simple overview of how mortgages work. First, to show you how simple this topic is, I will offer you the “Rule of 72″. If you divide an interest rate (6% in most MMA examples) into the number 72, you get the number of years it takes money to double. 6 into 72 is 12. So at 6%, it would take money 12 years to double. Now, let’s look at the first lines of an amortization table for a $200K 30yr fixed mortgage at 6%;
| Balance | ||||
| Month | Payment | Principal | Interest | 200000.00 |
| 1 | 1199.10 | 199.10 | 1000.00 | 199800.90 |
| 2 | 1199.10 | 200.10 | 999.00 | 199600.80 |
| 3 | 1199.10 | 201.10 | 998.00 | 199399.71 |
| 4 | 1199.10 | 202.10 | 997.00 | 199197.60 |
| 5 | 1199.10 | 203.11 | 995.99 | 198994.49 |
Here, we see that the monthly payment is $1199. What would we save at the end if we sent $100 more to the mortgage? Well, 24 years is twice the 12 it takes to double, so at 6%, in 24 years we’d have $400, another 6 years, and it should be worth close to $600, right? Well, back to the amortization schedule and we see that if we pay an extra $200.10 along with the mortgage payment due for month 1, we actually get a full month ahead on our schedule. Agents selling MMA use the word ‘canceled’ for this process, saying that “MMA canceled $999 in interest in just one month.” And in a case that lies north of innumeracy, and south of hyperbole, they suggest that you got a 500% return on your money, instantly. You can see how on one hand, the math is pretty easy, you can get very close without even using a calculator, yet on the flip side, one who doesn’t understand the numbers can be convinced of something not true. $200 today is the present value of $1200 30 years hence at 6%/yr. So, you can look at this 2 ways, the extra $200 payment pays the payment #360 in advance, as it knocks off the last payment due, or looking at above, you’ve just paid payment #2, and next month, you are on line 3 of the table. The amount you prepay against principal doesn’t need to be any particular amount. If you have $100/mo extra, over one year’s time you will have paid your mortgage ahead by about 6 months. To be clear on this last thought, using a spreadsheet on your computer will give you exact numbers, but even a printed spreadsheet you track with a pencil is all most people actually need to get the job done.
Next week, we will continue and conclude our discussion of mortgage math.
Joe
I’m paraphrasing, of course from Shakespeare’s,“The fault, dear Brutus, lies not in our stars, but in ourselves if we are underlings.”
In a recent story, covered by ABC as “Movement to Scrap 401(k)s Gains Traction” it seems that instead of (a) prompting more disclosure regarding the high fees with an eye toward reduction, (b) education about asset allocation (as in “how to not lose 100% of your savings in an Enron-style implosion”, and (c) a bit of counselling on proper planning, amount that needs to saved, etc, they are proposing we scrap the system altogether.
The current state in which we find the financial markets doesn’t call for the abolition of retirement planning as we know it. In the old days, whenever they were, a defined benefit pension would have provided a nice income at retirement, with social security adding to supplement. As people stayed at a given job for fewer years, the pension system made less sense. The 401(k) on the other hand, was a great replacement vehicle. Those frequently changing jobs had the choice of moving their prior account to the new employer or to roll the account to an IRA.
There are bits I picked up from the article that I agree with:
Encourage/force disclosure and lower fees
Mandatory 5% minimum deposit and 5% company match
An offering of one fund that invests in the inflation+3% as the plan proposes
This would satisfy much of what this democratic proposal offers, only it doesn’t tie the hand of investors who wish to be more aggressive and it doesn’t create a socialistic investment pool. The article doesn’t address the source of the inflation+3% investment, where exactly does one get this return? How will the government guarantee this, and who will make the investment decisions on our behalf?
I’ll just say “no, thanks” to this one.
Joe
