DEBT DIAGNOSIS

Inter­est — Rate vs Cost using 6% Mort­gage and 10% HELOC.

 

1. WHEN CAN YOU BORROW MONEY BUT NOT BE IN MORE DEBT? I am a strong advo­cate of get­ting out of debt as soon as pos­si­ble and stay­ing out as long as pos­si­ble. The dia­gram below shows how by bor­row­ing $5,000 from a home equity, per­sonal or busi­ness line of credit to use as a principal-only pay­ment to help pay off the bal­ance owing on a mort­gage, you aren’t really get­ting deeper into debt. You are really just repo­si­tion­ing the debt dif­fer­ently. Don’t you still owe the same $200,000 amount  but in a dif­fer­ent con­fig­u­ra­tion? Why do this? Keep reading.…..

 

One aspect of the Finan­cial Nav­i­ga­tion Solu­tion is a clas­sic exam­ple of bor­row­ing cheap money to make (or actu­ally “save”) inter­est dol­lars. It bor­rows money from a line-of-credit (ALOC) at one cost and uses it to pay down a mort­gage at a much higher cost. Notice, I did not say rate, I said cost. That is because the rate of the ALOC (advanced line of credit) usu­ally will be higher than the rate of the mort­gage, but the cost will be the other way around, because the rate of the LOC will be charged for a very short period of time (usu­ally less than three months) whereas the rate of the mort­gage typ­i­cally will be charged hun­dreds of months. That leads to the next fac­tor: 2. THE LENGTH OF A LOAN IS AS IMPORTANT AS THE RATE The third thing to under­stand is the impor­tance of the length of a loan com­pared to the rate of a loan. We have been sen­si­tized to the value of a frac­tion of a per­cent­age point in inter­est rates but rarely think about the impact upon net worth caused by how long the loan is spread out. Too often, bor­row­ers look only at monthly pay­ments to see if they can afford them with­out real­iz­ing that low pay­ments and even low inter­est rates often are cou­pled with a gar­gan­tuan inter­est oblig­a­tion when accu­mu­lated and com­pounded over many years.

Below is a spread­sheet depict­ing the effect of bor­row­ing $5,000 from a 10% LOC which has inter­est cal­cu­lated on an aver­age daily bal­ance, like a Home Equity Line of Credit and using that $5,000 to make a one-time Pre-payment (principal-only pay­ment) to a mort­gage being charged 6%, with the first sched­uled monthly payment.

 

 

So here we can see that the COST of bor­row­ing $5,000 from the line of credit charg­ing a rate of 10%, is a mere $208.31. What if this sce­nario showed only $500.00 monthly dis­cre­tionary income? What would that cost? Maybe $416.62. Next is an exam­ple of what the impact of bor­row­ing $5,000 from your Home Equity Line of Credit to make a Principal-Only Pre-Payment on your mort­gage is. Using the same mort­gage num­bers, a $200,000 mort­gage charged at a rate of 6% over 30 years, here is the result of adding $5,000 to your first sched­uled payment.

Repay­ing that $5,000 at $1,000 per month and also by reduc­ing the aver­age daily bal­ance by deposit­ing all of one’s income into the HELOC each month, has made this a very worth­while rea­son to bor­row at 10% to pay off a 6% loan and the rea­son one must con­sider more than just the inter­est rate when decid­ing to pur­chase, loan or refi. Do you think sav­ing $23,304 of inter­est pay­ments and 22 months of monthly mort­gage pay­ments off the back end of the mort­gage in this exam­ple was a wise rea­son to repo­si­tion your debt? How much risk was involved here? Would you want to trade $23,304 and 22 x $1199.10 = 26,380.20 for $111.82 or $223 or even $1,000 of ALOC inter­est charges? Go to my next blog post which goes through bor­row­ing mul­ti­ple times over the coarse of a year to see what that looks like. Here is a post about the most awe­some finan­cial tool I have been intro­duced to. I can now show you how using the same money you are pay­ing off your debts with can, at the same time, be build­ing wealth and a retire­ment fund for you. Plus much more. Con­tact me now for a free illus­tra­tion.