Should you get a fifteen or a 30 year mortgage? What about a bi-weekly payment plan? Should I double up my payments or add extra principle payments?
These are questions that millions ask and only a few have answers to – most of which are wrong. Sometimes the answers come from some staff reporter at a newspaper or someone with some expensive program to sell. Another problem is that they answer a question without the proper facts.
One Size Does Not Fit All
No one can answer these questions without first asking one. The question is what is the best “safe rate” of return you can get with your money.
Paying extra principle payments on your mortgage is a way to invest money at the rate of return of the interest rate of your mortgage. If you are paying 9% on your mortgage, then any extra principle payments are invested at that rate. Is that the best rate you can get? Are you in a position to invest the money. Extra money paid on a loan is sunk, you can not get it back easily and inexpensively. If there is no way that you will need the money back and feel this is your best rate, then it may not be a bad deal. Provided it is a “safe” rate.
Stay Away from the Ethically Disoriented
It isn't necessarily safe if you are giving it to a third party besides your mortgage company. Fraud or mismanagement can mean it may not get to your mortgage company and you are out the money. There are many cases where this has happened. My recommendation is never to give it to a third party. Work directly with your mortgage company.
On almost every loan you can make extra principle payments or raise your payment at any time. Even if there is a “pre-payment penalty” it usually provides that you can pay no more than 20% of the outstanding balance each year. This gives you a plenty of room to play. You do not need permission from your lender, though cooperation is helpful. They may have certain policies you need to know.
Your Crystal Ball May Be Cracked
You do not know what the future holds in the world or your own life. Always commit to the longest time period on loan repayment as possible. It is a simple calculation to decide how much extra to pay on a 30 year loan to pay it off in 15 years. For example, let's look at a $50,000 thirty year loan at 9%. The payment would be $402.31 per month.
$50,000 9% 360 months $402.31
$50,000 9% 180 months $507.13
An increase in the payment of $104.82 shortens the loan by one half.
It is a mistaken assumption to think you would have to double your loan payment to pay your loan off in half the time. If you doubled the payment to $804.62, the loan would actually pay of in 7 years (83.98 months).
You don't know when or if an extra 100 dollars may be needed. If you commit to a 30 year loan, you can always begin paying off on a 15 year schedule or any one you choose. If times grow hard, you can back off to the original period.
Having a higher payment on a loan can also make a property less desirable and salable to someone else. In addition, high payments can lessen the cash flow of a rental unit and it's resulting value. A single family home may become a rental later or if not, other potential buyers may find the payments too high. Do not commit to shorter time periods, but pay a loan off early if it makes sense for you.
Most of my students would find a 9% rate way too low to invest in. Investing in paper can achieve safe rates of return up in the 14 to 24 percent range. In that case, it makes much more sense to invest money at that higher rate. The results are far more impressive in the long run. After seeing this, many investors take larger loans against their properties and invest the cash in the higher rates provided by real estate paper. The investors end up tens to hundreds of thousands of dollars ahead when it is all over.
The Financing Fence
The person that really benefits is on the other side of the fence. Let's look at how a private mortgage holder might benefit from increased principle payments. We'll use the same $50,000 loan mentioned above and assume it was purchased at a 15% yield.
$50,000 9% 360 $402.31
$31,817 15% 360 $402.31
At a 15 year repayment schedule, the payment is higher and the value of the note is higher at the same 15% yield. The yield has increased based on the price we paid for the mortgage. Line 1 shows the new payment based on 15 years.
Line 2 shows what the note is worth at a 15% yield. Line 3 shows what the new yield is now that the mortgage has been restructured.
$50,000 at 9% for 180 months = $507.13
$36,234 at 15% yield 180 $507.13
$31,817 17.77% 180 $507.13
It would be possible to buy this note for $31,817, share the principle of accelerated mortgage reduction with the payor and then turn around and sell it at the same yield you bought it for and still make a profit of $4417.
By having a shortened term, the mortgage is more valuable and is actually more salable also. Many mortgage buyers do not like long term paper. The same mortgage buyer that turned down the note previously might now buy it because of the shorter term. The payor of the note, who probably hasn't a clue how to get a higher rate of return than 9% is also far better off with the mortgage restructured.
Saving $15,000 on a $10,000 Mortgage
How about a real attractive offer for someone paying on a note. Over the course of 30 years an incredible amount of interest is paid on a mortgage. Let's look at a way to save half of the interest almost painlessly. This involves a $10 dollar per year increase in the monthly payment. First the original note and it's purchase price at a 15% yield.
$10,000 10% 360 $87.76
$ 6,940 15% 360 $87.76
Raise the payment $10 per year and the loan will pay off totally in 9 years and 9 months. Over the life of the loan, this will save the payor $14,976.86 in interest. (The original loan pays out $21,593.60 in interest.)
The yield on our investment raises to 18.42% and the value of the note raises by over $1,000 to $7996.29.
No Cash Needed
Some may have already jumped ahead and concluded that neither of these transactions requires that you own the mortgage. In fact, most of the ways to improve mortgages do not require that you own them or at least own them for long to realize tremendous profits.
It is a shame to hear all the transactions where potential mortgage buyers pass up mortgages for a few dollars in price or because they do not have sufficient financing. You should explore some of the options by talking to the payor on the note. Sometimes the notes that are the least marketable are the easiest to improve. What you have that many of the institutions and individuals out there sometimes lack is a creative mind that explores alternatives and options. Behind most problems lies a profit.