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

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……

borrow_from_aloc

 

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.

MMA-5-differences-heloc-mortg

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.

MMA_pre-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.
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September 3, 2009 · Jennifer · No Comments
Tags: , , , , , , , ,  · Posted in: Interest - Rate vs Cost, When Can You Borrow Money But Not Be In More Debt?

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