Jul212015

Accelerate loan amortization to pay off mortgage debt quickly

Paying off a promissory note early removes the mortgage encumbrance and turns a real estate borrower into a property owner.

doesnt_pencil_mortgageMost people realize their dreams of home ownership when they borrow hundreds of thousands of dollars to purchase a house. This is not ownership; it is debt slavery. People don’t own the property until the debts are retired, and true home ownership is the reward for those who master paying debts faster.

Affordability is a measure of people’s ability to raise money to obtain real estate, a function of financing. During The Great Housing Bubble, financial innovations dramatically increased the amounts people were able to borrow; unfortunately, Affordability Products Make Prices Unaffordable. The affordability was short lived because the loan programs themselves were unstable. The collapse of these loan programs resulted in a massive credit crunch that removed affordability from the market; prices fell.

During The Great Housing Bubble, the loan programs were unstable and interest rates were too low because lenders were not property pricing risk. Now, the Federal Reserve has artificially engineered unsustainably low 3.5% Mortgage Interest Rates? to compensate for the affordability lost when toxic loan programs got crunched. In short, we substituted unsustainable interest rates for unsustainable loan programs — the key word being unsustainable.

I expressed my believe that interest rates won’t rise in 2015, but in a series of recent speeches, the chairman of the federal reserve, Janet Yellen, has bluntly stated that interest rates will go up this year. While the timing may be uncertain, the direction of mortgage rates in future years is very likely to be up.

Is it about the payment?

pay_the_mortgageIt is worth noting here that lower prices does not increase affordability. What? Yes, that is right, lower prices does not necessarily increase affordability. A house loan of $460,509 at 4.5% has the same payment as a $317,995 loan at 8%. The loan balance is 31% smaller, but the payments are the same.

(See: How mortgage interest rates affect homeownership costs)

From a cashflow investment perspective — assuming the property will never be sold — the Federal Reserves efforts to lower interest rates has increased affordability; however, Like the loan programs the FED initiative replaces, ultra-low interest rates are not sustainable.

Rising Rates Makes Rental Parity Important

My advice to potential homebuyers is to find a property at or below rental parity that they want to live in long term. Buyers who purchase with this understanding are insulated from the potentially negative consequences of rising mortgage rates.  If an owner wants to move when resale values are depressed — and people endure unexpected life changes — then they can rent the property out for enough to cover their expenses rather than sell and take a big loss.

If the owner paid far more than rental parity, then they must either take a huge loss or bleed cash each month to cover the deficiency. Those who were in these circumstances after the bubble collapsed can attest to how painful it is to throw bad money after a bad investment.pay_our_debts

On an inflation adjusted basis, buyers never recover from overpaying up front, but in nominal terms, there will come a point when they can get out at breakeven. Keep in mind, they are trapped in an underwater situation once interest rates start going up and values start going down; however, they are trapped in a property that still costs less than renting.

From a purely cashflow perspective, buying now is not a problem; however, in the real world, people need to sell their homes for many reasons. If they are underwater when they need to sell, bad things happen. Who is willing to take that risk?

Pay more when you can

Retiring debt is part of the cashflow investment mindset; it is diametrically opposed to speculation. Retiring debt is the key to retiring from work. The faster you can accelerate the repayment of debt, the sooner your investments are paid off, and the sooner you can retire.

There are methods anyone can use to accelerate their home mortgage payments: (1) pay more when you get a raise and (2) make extra payments.

One of the advantages of home ownership is that you have a stable house payment while renters face yearly increases. Why not take that raise and put some of the extra into your payment? If you get a 3% raise, you should be able to put 3% more toward your mortgage. If you do this, a 30-year amortization drops to 20 years.

Another method people use to pay down their mortgages is to make extra payments. If you are like the many people who are paid every two weeks, you get what seems like two extra paychecks a year. If you make one extra payment a year, you can pay off your mortgage five years early. If you can make two extra payments a year, you can pay it off almost eight years early.C:UsersLarryDocumentsDrawing1 Model (1)

If you combine both methods, you can pay off your mortgage in 16.5 years!

This plan does not require heroic efforts. You are putting the same percentage of your income toward housing, and you are spending part of two extra paychecks per year. It that too much to ask in order to pay off your debts early? Good financial planning can accelerate your retirement by many years. Do you want to work longer than you need to?

Refinancing for accelerated amortization

During The Great Housing Bubble, and even now, most people who refinance do not accelerate their amortization. If given the chance, most people will suck the equity out of their home and spend it. The more conservative ones will refinance into a lower payment and enjoy more spending money that way. What I am proposing is the most conservative alternative; take out no money, make the same payment, and pay off the debt quicker.

Time to Payoff

The Time-to-Payoff is the amount of time it takes to retire the debt used to acquire the asset (house). biggest_saverWhen people examine investments, they often look at rates of return to compare between asset classes. Rates of return are a valuable metric. When thinking about retirement finance, rates of return become less important than steady cashflow. We need a new measure of success for reaching your retirement goals: Time to Payoff.

Paying off debt is as difficult as dieting — there is always a temptation — whether it be spending or eating. The success rates for debt retirement are no better than they are for weight loss. Perhaps we should have a TV Show for the Biggest Saver.

Calculating Time-to-Payoff is a challenge. It requires looking at the available sources of cashflow and the impact the property has on its owner. There is a level of cashflow that can be diverted toward debt service that otherwise does not impact the owner’s life.

For example, if a property is about $600 per month cashflow positive before debt or taxes, the debt service payments can actually be closer to $900 per month before the owner is truly cashflow negative. How can this be? Isn’t paying out $300 a month more in payments making you cashflow negative? Not really. Part of that payment is equity that is paying down debt, so that is not a true expense. The interest will be tax deductible for most wage earners, so the owner can adjust paycheck withholdings to compensate for the difference in payment. In short, the property has no net financial impact on the owner.

If the property is cashflow positive — which it must be for this analysis to work — there will be money that can be put toward debt service. If the maximum available cashflow is put toward debt service, how quickly does the loan amortize? That is Time to Payoff.

If you invest in the Time-to-Payoff way, your property investments will have no impact on your financial life — plus or minus — until you retire. There is no demand on your income to service the investment, and there is no net benefit for you to spend on your lifestyle. Let’s just say, it isn’t a lifestyle alternative many people were choosing during The Great Housing Bubble.

Time-to-Payoff Spreadsheet

If you want to experiment with different scenarios to see how quickly you can pay off your mortgage, download the spreadsheet below.

Download (XLS, 120KB)

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