All Forum Posts by: Eric Jones

Glad to see some others chiming in too. When I get a chance, I'll try to model the scenarios that @David Dachtera and @Account Closed described. Be back in a bit...

@David Dachtera @Account Closed

I agree that it works - I'm just saying that it works because you're paying extra beyond the minimum payment. It has nothing to do with amortization vs simple/compound interest. People say this sometimes and it's just plain wrong. The people I see proposing this are correct in saying that it works, but they get the WHY wrong. This applies to this video as well - the speaker doesn't fully understand how the math works.

Here's a very simple illustration using the same $100k loan @ 5% over 360 months. Since the goal is rapid paydown, we will assume a monthly payment of $1000 for the example. So we are paying more than the minimum...

AMortized Loan:

Beginning balance = $100,000

Interest accrued over 1 month = $100,000 * 0.05/12 = $416.67

Monthly (amortized) payment = $536.82

Additional prepayment = $436.18 

So the total monthly payment = $536.82 + $436.18 = $1000

At the end of the month your balance will be = Loan balance + Interest accrued - Monthly Payment - Prepayments so: $100,000 + $416.67 interest - $536.82 monthly pmt - $436.18 prepayment = $99,416.67 <== this is your balance at the end of the month.

HELOC:

Average daily balance over month, assuming you make a single payment at month end = $100,000

Interest accrues over one month on a daily basis = $100,000 * 0.05 * (365/12) / 365 = $416.67

Make a lump sum payment of $1000

At the end of the month your ending balance will be = $100,000 + $416.67 interest - $1000 payment = $99,416.67 <== notice it is exactly the same as the ending balance for the amortized loan.

So if the ending balances are exactly the same, there is absolutely no benefit to paying it off with a HELOC since the end result is the same. Notice that interest is calculated on the loan balance - doesn't have anything to do with amortization. Where amortization comes into play is in the calculation of the "Monthly (amortized) payment" of $536.82 above. So the fact that it's amortized means that if you JUST pay the minimum, it will payoff in 30 years. Same thing applies to ARMs, except you recast the loan at each rate adjustment interval, to calculate a new amortized payment.

Don't trust everything you read or see online/Youtube. Do the math for yourself and you can see that a prepayment on an amortized loan is identical to making an equivalent lump sum payment on a HELOC. Hope this clarifies it - if not, I'll leave it to others to attempt an explanation!

@David Dachtera,

I saw enough to know the strategy and how it works - like I said, I've seen this before. We are in agreement that the strategy works as described, but we differ as to WHY it works. I'm saying that it works because you're prepaying, and you're saying that it works due to something unique and intrinsic of the HELOC itself, but that is not the case. Perhaps I'm not explaining it well and some others can clarify it better.

We're on the same page with HELOCs being great tools. In fact, I think the HELOC is up there with reward earning credit cards as one of the best financial products ever created. I just don't use HELOCs for the purpose your describing. I use it to quickly, easily, and cheaply deploy cash for investments, repairs, etc. So at least we can both agree that HELOCs are awesome! But a tool for quicker debt payoff... I don't think so.

@David Dachtera ,

Checked it out... it's exactly what I expected and what I've seen in the past. There's nothing magical about this. All it's doing is applying excess cashflows in your budget to principal payment. So yes, you're saving a lot of money in interest, but it's NOT due to how the interest is calculated (amortizing vs simple interest), it's due to the fact that you're making regular prepayments with excess cashflows in your budget. You could accomplish exactly the same thing by not using the HELOC, and applying the excess cashflow directly to the loan via prepayments. I can prove this quite easily mathematically, but won't bother here. Don't fall for this! It's not a scam per se, but it's unnecessary and is designed for people who don't have the financial discipline to apply their excess cashflow to debt paydown. It automatically does it for you, assuming you have excess cashflow.

@David Dachtera - 

Again, I'm not talking at all about PAYMENT calculations. I'm talking about INTEREST calculations. I agree that payments are calculated differently between an amortized loan and a HELOC. That's not the topic of discussion - we're talking about saving INTEREST using a HELOC payoff strategy versus a traditional monthly payment strategy. You're misunderstanding my main message, which is that the interest savings are miniscule, but there are some very minute savings due to the fact that you can slightly lower your average daily balance on a HELOC using the method described above.

To demonstrate this, if you have a $100K balance amortized over 360 payments @ 5% your monthly payments are $536.82. For payment #1, $416.67 goes to interest and $120.15 goes to principal. 

If you instead have a $100k balance on your HELOC @ 5%, and you make the same $536.82 payment as you did above (apples to apples), you will get the same breakdown of interest and principal (assuming you make a single monthly payment at the end of the month). The fact that your minimum PAYMENT on the HELOC might be much less (1/120th like you mentioned, for example) than your minimum payment on the amortized loan is totally irrelevant. Point is, they both accrue interest at the same rate, regardless of how your minimum payment is calculated. Make sense?

I checked the math and you're exactly right. So you end up saving $12.63 the first month, due to the timing of the payments, which effectively reduced the average daily balance from $100,000 to $95,143.97. So you're paying interest on $95,143.97 instead of on $100,000. Assuming you'd continue to accrue monthly savings of $12.63 every month (which you wouldn't, since the balance and therefore interest accrual is dropping each month), you're payoff term would be 28.46 years instead of 30 years - mathematically the same as applying a $12.63 prepayment each month on the amortized loan. In reality, I'd be surprised if it knocked a year off the mortgage term. 

The formula I mentioned above applies here - what has changed isn't how the INTEREST is calculated, it's how the interest-bearing BALANCE is calculated.

The guys I've heard promoting this method claim you can get payoffs of only 8-10 yrs, which is clearly not the case. This can only happen if you have a lot of surplus cashflow/prepayments that gets applied to the HELOC each month. So you can achieve a very small financial savings due to how the average daily balance is calculated on a HELOC... but would you rather tie up your HELOC to save $12.63 in interest a month, or use those funds to make more profitable investments?

@David Dachtera - Thanks for the response David. 

The scenario that you're describing is one where you're essentially just prepaying the mortgage. So you're making your standard monthly mortgage payment, while simultaneously making occasional lump sum prepayments via the HELOC. Of course that will rapidly payoff your mortgage - you're prepaying! But I think the original question had to do with making just the standard payments - @Joe Au: "They make it sound like you don't have to pay extra every month". The question implies that simply trasferring debt from an amortized loan to a HELOC will result in a quicker payoff, assuming you're making the same payments on both, and at monthly intervals. Which is not the case...

The HELOC payoff schemes that I think Joe's referring to typically work where you make a lump sum payment to your mortgage via your HELOC. You then stop making payments on the mortgage, and dump all of your income as payments towards the HELOC. For your expenses, you pay those with the HELOC. During this time, your mortgage is accruing interest and it's capitalizing via negative amortization. Assuming you're cashflow positive, you will paydown the mortgage faster, but that's only because the excess cashflow is essentially just prepaying. It's mathematically the same as prepaying.

Lastly, the formulas are all correct. Amortization affects how the PAYMENT is calculated, not the interest. Interest is ALWAYS calculated as: Loan Balance * Interest Rate / compounding periods (n). The only difference between an amortized loan and a HELOC is how the Loan Balance portion of the equation is calculated - for HELOCs it's based on the avg daily balance, and for amortized loans it's the ending balance from the previous month after payments were applied. The reason that amortized loans are "front loaded" with interest is because the balance is high and it's accruing interest rapidly. There's nothing magical about amortization - the key to beating amortization is to prepay, not shuffling debt around while still paying the same amount.

@David Dachtera - when you simply transfer debt from a mortgage to a HELOC, although you do pay less interest on the HELOC itself, you have negative amortization simultaneously occurring on the amortized loan (aka "capitalization"), so your principal grows and you accrue interest on the new, larger balance. It turns out that the savings you achieve on the HELOC will be equally offset by the negative amortization/capitalization occurring on the amortized loan. And this is due to the fact that 5% of $1 is 5 cents regardless of whether it's simple or amortized interest. Simply changing the compounding interval from monthly accrual (amortized loan) to average daily balance (HELOC) doesn't affect the amount of interest you pay, assuming you make payments on a monthly basis.

Amortization is just a term to describe how a series of future payments are calculated so that they are equal throughout the loan life, accounting for both principal and interest. 

One way that you can legitimately save (a tiny bit of) money with a HELOC is to make weekly, biweekly, or bimonthly payments. For example, assume you have a $10,000 balance @ 5%:

On your amortized loan, in one month you will accrue: $10,000 * 0.05/12 = $41.67 in interest, so if you made a $500 payment, your new total balance would be $9,541.67

But if you make two $250 payments in a month on your HELOC, you're average daily balance over the month would be: ($9,750 * 0.05 * (30.42/365) = $40.63 in interest, so your end of month balance after both payments would be $9,540.63. So you can save $1.04 per month by paying bimonthly on a HELOC vs. monthly on an amortized loan, making the same total monthly payment.

Since a dollar accrues interest at the same rate regardless of interest type, there is no mathematical way to payoff a loan quicker by simply transferring a balance. The only possible way to payoff a loan quicker is to pay a larger amount overall, or get a better interest rate. Simply shuffling debt while making the same net payment will result in the same payoff time.

Good to know - I wasn't aware that HELOCs aren't bound by Fannie/Freddie guidelines. Thanks!

Hello, quick question - I'm in the process of opening a larger HELOC on my primary residence, which I own free and clear. In two to three years I plan on moving and renting out my house - is it okay to continue drawing on the HELOC while it's a rental? I'm thinking it should be fine considering I will be opening and using it as an owner occupant for 2-3 years, and as long as I make timely payments the bank would have no reason to shut it down or restrict it in some way. I can't imagine they'd rather forego the monthly interest payments just because it's a rental property. Anyone have experience with this?