Tuesday, January 31, 2017

The Best Way to Pay Off Your Mortgage



In writing this piece I must admit that it is not the piece I wanted to write. A colleague of mine introduced me to a service called the Worth Account (www.worthaccount.com). I respect my colleague deeply, and while I wanted so badly to recommend his product as a way for consumers to beat their debt, I unfortunately cannot do so having scrutinized the math behind it.

Briefly summarized, the Worth Account is a computer program that calculates the best combination and sequence by which to pay off an individual’s total debt based on their income and the application of their savings to paying off their debt ahead of time. It’s a program that one can purchase for a variable price (based on the savings calculated over time with its implementation), and can cost anywhere from a few hundred to a few thousand dollars depending on one’s debt.

But…

Does their premise hold true?

Let’s look a little closer.

The basic premise of the worth account is that its algorithms calculate the maximal amount of disposable income one can apply to their debts as a whole, and then calculate the optimal allocation of said disposable income to make extra payments towards those debts to pay them off with a minimal amount of interest paid in the shortest amount of time.

I will not go into whether the Worth Account is actually worth it or not as that depends on one’s debts, financial situation, income, discipline, and propensity to save. Instead, let’s focus on payment methods.

There are essentially three ways to make a payment on a debt. First, one can make a monthly payment with no extra payments towards principal. Second, one can make an extra payment every month in addition to their minimum payment. Third, instead of an extra regular monthly payment, one can periodically make a large payment towards the principal at arbitrary (regular or irregular) intervals, for example, applying one’s tax refund to their mortgage principal, or paying the equivalent of the regular monthly payments, but doing so quarterly, semi-annually, or some other way.

While some may think that making bi-weekly payments or some other partial payment scheme is also a possibility, banks typically do not apply partial payments to the balance of the loan. Such payments are typically held by the bank until a full payment is made, at which time such payment is applied, or just returned to the borrower outright, effectively eliminating any interest cancelling benefit perceived by the partial payment (http://www.thetruthaboutmortgage.com/biweekly-mortgage-payments/). Therefore, such schemes will be ignored for this article.

Most payment schemes will be variations of these three. Refinancing and other types of borrowing from one source to pay off another will not be covered in this article.

Take a hypothetical loan with the following parameters:

-          30 year fixed loan (360 monthly payments)
-          4.5% interest rate
-          $200,000 principal

The monthly payment on this loan will be $1,013.37 based on its normal amortization.




After the first year, with no extra payments, the amortization will be thus:

Payment
Principal
Interest
Amortization
Total Interest
Balance
1
200,000.00
750.00
263.37
750.00
199,736.63
2
199,736.63
749.01
264.36
1,499.01
199,472.27
3
199,472.27
748.02
265.35
2,247.03
199,206.92
4
199,206.92
747.03
266.34
2,994.06
198,940.58
5
198,940.58
746.03
267.34
3,740.09
198,673.23
6
198,673.23
745.02
268.35
4,485.11
198,404.89
7
198,404.89
744.02
269.35
5,229.13
198,135.54
8
198,135.54
743.01
270.36
5,972.14
197,865.17
9
197,865.17
741.99
271.38
6,714.13
197,593.80
10
197,593.80
740.98
272.39
7,455.11
197,321.40
11
197,321.40
739.96
273.42
8,195.06
197,047.99
12
197,047.99
738.93
274.44
8,933.99
196,773.55

Applying a regular monthly payment of $750 to the principal will yield the following amortization:

Payment
Principal
Interest
Amortization
Total Interest
Balance
1
200,000.00
750.00
1,013.37
750.00
198,986.63
2
198,986.63
746.20
1,017.17
1,496.20
197,969.46
3
197,969.46
742.39
1,020.99
2,238.59
196,948.47
4
196,948.47
738.56
1,024.81
2,977.14
195,923.66
5
195,923.66
734.71
1,028.66
3,711.86
194,895.00
6
194,895.00
730.86
1,032.51
4,442.71
193,862.49
7
193,862.49
726.98
1,036.39
5,169.70
192,826.10
8
192,826.10
723.10
1,040.27
5,892.79
191,785.83
9
191,785.83
719.20
1,044.17
6,611.99
190,741.66
10
190,741.66
715.28
1,048.09
7,327.27
189,693.57
11
189,693.57
711.35
1,052.02
8,038.62
188,641.55
12
188,641.55
707.41
1,055.96
8,746.03
187,585.58

In this next case, comparative to $750 per month, we will add $3,000 towards principal every four (4) months.
Just to ensure comparability, $3,000 x 3 payments (one every four (4) months of the (12 month) year) = $9,000. $9,000 divided by 12 months = $750/month.

Payment
Principal
Interest
Amortization
Total Interest
Balance
1
200,000.00
750.00
263.37
750.00
199,736.63
2
199,736.63
749.01
264.36
1,499.01
199,472.27
3
199,472.27
748.02
265.35
2,247.03
199,206.92
4
199,206.92
747.03
3,266.34
2,994.06
195,940.58
5
195,940.58
734.78
278.59
3,728.84
195,661.98
6
195,661.98
733.73
279.64
4,462.57
195,382.35
7
195,382.35
732.68
280.69
5,195.25
195,101.66
8
195,101.66
731.63
3,281.74
5,926.88
191,819.92
9
191,819.92
719.32
294.05
6,646.21
191,525.87
10
191,525.87
718.22
295.15
7,364.43
191,230.72
11
191,230.72
717.12
296.26
8,081.55
190,934.47
12
190,934.47
716.00
3,297.37
8,797.55
187,637.10

Such a large extra payment is typically not within reach of the average homeowner. For illustrative purposes, the amount allocated to extra payments is not entirely important so long as it’s comparable between methods.

Comparing the two methods, making an extra payment per month yields a slightly larger reduction in principal than the periodic lump sum payments.

This is so because of the principle of compounding interest. Even though the difference is relatively slight for the first year, because the loan is allowed to compound on the interest that, under the lump sum scheme, has not been paid for that month as compared to the monthly payment scheme, the slight effect of such compounding adds up over time.

While it yields a difference of $51.52 per year (perhaps a decent dinner for two), over the course of thirty years, these two payment plans compare thusly:

Amortization + Extra Payments per year
Total Interest
$60,970.91
Extra Amount per Payment
750.00
Total Payments
$260,970.91





Amortization + Lump Sum Transfers
Total Interest
$61,804.05
Frequency:
4 months
Extra:
$3,000.00
Total Payments
$261,804.05







This scenario assumes that cash is available to make such extra payments, and even so, the difference is $833.14 in favor of simply making equivalent monthly payments.

If one assumes that new debt will be issued (such as a credit card advance, let’s assume at an 8.333% annual interest rate) to cover the cash payments towards a larger loan, the summary is as follows:

Borrowing to pay extra
CC Interest
538.25
Mortgage Int.
$61,804.05
Savings:
($1,371.38)
Total Interest
62,342.29
Total Payments
$261,804.05







While this data alone will not summarize or justify every situation, when considered alone, it is clearly advantageous to stick to a simpler, steadier, consistent monthly payment plan to pay off the loan as quickly as possible with minimal outlays towards interest.

The problem with presentations such as the Worth Account, however, is that they do not compare scenarios like the comparison above. Instead, they compare their scenario with not making any extra payments at all, which looks like this:

Base Amortization (No extra Payments)
Total Interest
$164,813.42




Total Payments
$364,813.42







Of course making some extra payments is always better than making no extra payments. However, if one is charged even 1% of the supposed savings between the schemes presented and not doing any extra payments at all, then one would be convinced that they are saving $102,471. 1% of that would equal $1,024.71. That expenditure would wipe out the entirety of the savings gained by simply making equivalent monthly payments without having to pay for the program.

In essence, the consumer is paying for the program to cost them even more money.

1 comment:

  1. I think this is a really good article. You make this information interesting and engaging. You give readers a lot to think about and I appreciate that kind of writing.
    Singapore Shelf Companies

    ReplyDelete