Download Report

A Keystone Financial Solutions, P.C. White Paper
47 Marchwood Road
Suite 2-G
Exton, PA 19341
610-594-2601
www.keysolutions.us
Home Equity Loan Management (HELM)
How to Accelerate the Payoff of Your Mortgage
And
Save Thousands of Dollars in Interest
By Frank Haarlander, CPA, MBA, MS-Tax
CONTENTS
Page Number
Introduction
1
Disclaimers
1
What is a Mortgage?
2
How is Mortgage Interest Computed?
2
Traditional Mortgage Acceleration Techniques
3
What is the Rate of Return on your Home Equity?
4
Other Home Ownership Considerations
5
Home Equity Loan Management (HELM) Qualifications
5
How Does the HELM Program Work?
6
Advanced HELM Retirement Strategy
7
Is the HELM Plan for You?
8
Summary
8
Acknowledgements and Footnotes
9
INTRODUCTION
I have written this paper to educate its readers to better understand some pertinent financial
aspects of home ownership. This paper is not meant to be all-inclusive. Rather, it is a primer
designed to address a limited number of pertinent financial issues that homeowners will likely
face during their home-ownership years.
This paper will principally focus on how homeowners can accelerate the payoff of their
mortgage and save thousands of dollars in interest. While many homeowners are familiar with
the more common techniques of how to accelerate the payoff of their home mortgages, most
are not familiar with the HELM plan discussed in this paper. While this paper principally focuses
on mortgage acceleration techniques, it also briefly mentions how much of a down payment to
make and the term of the mortgage loan as these factors are directly related to mortgage
acceleration.
The author is available to discuss any topic with you should you wish to engage Keystone
Financial Solutions, P.C. (“KFS”) for a more detailed discussion that will be tailored to your
particular facts and situation.
DISCLAIMERS
This paper is intended for educational use only. I am not assuming any responsibility for errors
and omissions and specifically disclaim any liability resulting from the use or application of the
information contained herein. This information is not intended to replace or supplement any
legal, tax, financial, or any other advice related to your individual situation. If you need
individual advice on the topics covered in this paper, please contact me or another qualified
professional for an individual consultation. You should always seek counsel from a competent
advisor before taking actions based on this or any other publication.
Pursuant to IRS Circular 230, I am required to advise you that any advice included in this
communication, including attachments and enclosures, is not intended or written to be used,
and it cannot be used by you or any other person or entity, for the purpose of avoiding any
penalties that may be imposed under the Internal Revenue Code or applicable state or local
tax law provisions.
1
WHAT IS A MORTGAGE?
Per Freddie Mac1, “A mortgage is a loan secured by a property/house and paid in installments
over a set period of time. The mortgage secures your promise that the money borrowed will be
repaid.”
HOW IS MORTGAGE INTEREST COMPUTED?
Before introducing you to the HELM concept, I believe it is necessary to discuss the more
traditional techniques of accelerating mortgage payoffs. While the author acknowledges that
this section is not exciting reading, it is vital that you understand these techniques and how
mortgage interest is computed if you are to fully appreciate how the HELM plan works.
In the United States, interest is paid in arrears and is computed daily. Paid in arrears means
your monthly mortgage payment will pay the interest for the 30-day period immediately
preceding your payment due date. In other words, when you make your monthly mortgage
payment due on the first of the month, e.g., March 1, you are paying the interest for the entire
preceding month, February. This concept is important to understand because most mortgage
acceleration programs involve making additional principal payments. When you accelerate a
mortgage payment, that additional payment decreases the daily interest charged on your
mortgage loan.
Let’s assume that a home is purchased on January 1 for $125,000 and a 20% down payment is
made. The mortgage balance of $100,000 will be repaid over a 30 year term at an annual
interest rate of 7%. The monthly mortgage payment would be $665.30 per month.
The homeowner needs to understand that in the early years of the loan, most of the monthly
mortgage payment is applied to interest and not principal. The interest portion of the first
monthly payment is $583.33 (88% of the total payment). This amount is calculated by
multiplying the outstanding mortgage balance ($100,000) by the annual interest rate (7%) and
dividing that result by 12 (the number of months in a year). This computation is repeated month
after month. Thus in the second month, the outstanding mortgage balance of $99,918.03
($100,000 less the principal portion of the first monthly payment of $81.97) is multiplied by 7%
and divided by 12 to compute the interest portion of the second monthly payment. The
principal portion of each payment is simply the difference between the total payment and the
interest portion of that payment. For the first month, the principal portion of $81.97 was the
difference between $665.30 total monthly payment and the interest portion of $583.33. Using
the terms of this particular mortgage note, the monthly payment remains predominantly
interest until year 20. Beginning with the 242nd monthly payment (20 years into the 30 year
mortgage note), the principal portion of the payment is $332.98 and the interest portion is
$332.32. If the monthly payment of $665.30 were made for the 30 year term of this mortgage
note, the homeowner will have paid the lender $139,508.90 in interest. Ignoring present values
and tax deductible mortgage interest, the $125,000 home has cost the homeowner $264,500
(rounded).
2
Since the American Dream for many homeowners is to own their home debt-free and to avoid
paying the lender as much interest as possible, many homeowners accelerate their mortgage
payments. Let’s take a look at the typical mortgage acceleration techniques that are used.
TRADITIONAL MORTGAGE ACCELERATION
TECHNIQUES
Round-Up Your Mortgage Payment: Using the above example, the homeowner may wish to
round up the monthly mortgage payment by $34.70 and remit $700 per month rather than the
required $655.30. If the homeowner did this, the homeowner would pay $23,873 less in
mortgage interest and accelerate the payoff of the mortgage balance by 52 months.
Make an Annual Bonus Payment: Let’s assume that the homeowner wishes to accelerate the
payoff of the mortgage loan balance by making an annual bonus payment to pay down the
mortgage. Let’s assume that the homeowner makes the annual payment in December for the
amount of $416. This amount was chosen because it represents the rounded up amount of
$34.70 multiplied by twelve months. In other words, rather than making 12 monthly additional
payments of $34.70, the homeowner makes one annual payment of $416. Will the total interest
savings be more or less than in the previous example? If you understand that the mortgage
interest is computed on a daily basis, the answer is simple. The mortgage interest savings will be
less. Why? Because the mortgage interest is computed on each month’s outstanding mortgage
balance. In the first example of rounding up the monthly mortgage payment, the outstanding
mortgage balance is deceased each and every month. If the bonus payment is made in
December of each year (remember the mortgage loan began in January), the principal balance is
reduced in the twelfth month rather than in each of the first eleven months. On the other hand,
if the annual bonus were made in January, the interest savings would be greater than if the
monthly acceleration payment plan were used.
Some homeowners actually over pay their taxes each year so that they receive a refund from
the IRS and thus have the funds available to make the annual bonus payment. This is equivalent
to giving the IRS an interest-free loan and such planning needs to be re-evaluated.
Make Bi-Monthly Payments: Rather than making one monthly payment of $665.30, the
homeowner makes two monthly payments of $332.65. Will the homeowner’s total interest
decrease? By now you realize that since the homeowner is making an additional payment
before the required monthly due date, the total interest paid will decrease. How much will the
homeowner save? Surprisingly, the total interest paid by the homeowner over the life of the 30year mortgage will be $139,146.09. The homeowner will save $362.81 in interest and pay off the
mortgage one month earlier2.
Pay the Equivalent of 13 Monthly Payments: If the homeowner made an additional $55.44 per
month payment (equal to the annual payment of $665.30 divided by 12), the homeowner will
pay $105,367.50 of interest over the life of the loan, save $34,141.69 in interest, and pay off the
mortgage in 285 months2.
3
Pay $332.65 Bi-Weekly: If the homeowner made payments of $332.65 every two weeks, the
homeowner will pay $105,046.26 of interest over the life of the loan, save $34,462.64 in
interest, and pay off the mortgage in 284 months. Bi-weekly payments (26 payments each year)
should not be confused with bi-monthly payments (24 payments each year) 2.
While penalties associated with the prepayment of mortgages is no longer a prevalent practice,
homeowners need to confirm with the lender that prepayments of principal are not subject to
any type of prepayment penalty. Homeowners also need to confirm with their lender exactly
how the lender will apply prepayments to ensure that the payment is immediately credited
against the mortgage balance upon receipt.
Using the assumptions in this analysis, the best acceleration plan was the bi-weekly plan which
accelerated the mortgage payoff by about six years and was slightly better than making the
equivalent of 13 monthly payments. Homeowners are not limited to any one of these
acceleration plans and can combine them. For example, the homeowner could round up the biweekly mortgage payment of $332.65 and also make an annual bonus payment. All of the
mortgage acceleration techniques discussed in this section required the homeowner to make
additional mortgage principal payments. In other words, the homeowner had to change his
spending habits to accelerate the mortgage payoff.
WHAT IS THE RATE OF RETURN
ON YOUR HOME EQUITY?
When meeting with homeowners and discussing home equity with them and their desire to pay
off their mortgage balances as soon as possible, we ask them the following question. If you and
your next-door neighbor purchased identical homes on the same day for the exact same price,
and you paid for your home in cash and your neighbor financed 100% of the purchase price,
which home would be worth more today? The majority of people respond that their home
would be worth more because it has no mortgage on it. The correct answer is that both homes
should be worth exactly the same. The appreciation of the home is dependent upon many
factors. However the mortgage balance on the home is totally irrelevant with respect to its
appreciation. Since the two homes are identical, their appreciation is the same.
Why do we ask this question? The answer is that the cash that was used to purchase the home
and subsequent principal payments earned exactly a zero rate of return. That money could
have been safely invested elsewhere and earned the homeowner something. Thus when
deciding how much of a down payment to make, the homeowner needs to consider the zero
rate of return on his equity investment. While one can argue that the mortgage interest rate
paid would likely exceed the rate of interest earned on the monies not used for the down
payment, the question needs to be asked because few homeowners consider this factor when
determining how much a down payment needs to be made.
4
OTHER HOME OWNERSHIP CONSIDERATIONS
Term of Mortgage Loan: The term of the mortgage loan is one of the factors that determine the
monthly mortgage payment. The longer the term (15, 20, 25, 30-year) is, the lesser the monthly
payment. For example, the example discussed earlier had a term of 30 years which resulted in a
monthly mortgage payment of $665.30. If a 20-year term were used instead, the monthly
payment would be $775.30.
When working with homeowners, we often observe that they desire the shortest mortgage
term that they can afford because they want to limit the overall interest paid for borrowing the
money to purchase the home and because a lower rate of interest will generally be charged on a
shorter-term note because the lender’s risk has decreased. Many of these homeowners realize
that they are stretching their financial resources to obtain the shorter term loan, but usually
justify their actions by saying that while the mortgage payment is a fixed amount (assuming a
fixed rate of interest), their salaries will increase. The homeowner will block out from their list of
possibilities what happens if one of the spouses loses their job, if an unexpected addition to the
family arrives, or if they have unexpected expenses (new roof, medical, etc.).
For those homeowners who are stretching their financial resources, we believe that they should
consider taking the longer term mortgage to lessen the strain on their financial resources and
consider implementing the HELM plan to pay off the mortgage early and reduce their overall
interest cost.
Asset Protecting Your Home: A discussion of how to asset protect your personal residence is
beyond the scope of this paper. However, asset protection is a very important aspect of home
ownership that unfortunately is often ignored. Since a personal residence is one of the most
valued assets that people own, the topic of asset protecting your home should be part of
everyone’s overall financial plan. The average person has no idea as to what their state of
residence’s homestead rules are. While Florida and Texas have excellent homestead rules, many
states afford little protection. For those homeowners who desire or feel a need to asset protect
their home from potential claimants, they should consult with an attorney who specializes in
asset protection.
Another factor that is often ignored when deciding how large of a down payment to make on a
new home purchase or when deciding to accelerate the payoff of the mortgage is which house is
more attractive to a future claimant? Obviously the home that is highly leveraged is less
attractive to a claimant than a home that is debt-free.
HOME EQUITY LOAN MANAGEMENT (HELM)
QUALIFICATIONS
What if I were to tell you that it was possible to pay off your mortgage much faster than the
traditional methods discussed earlier? What if I were to tell you that you could pay thousands of
dollars less in interest (depending upon the loan balance and when the HELM program is
5
implemented in the life of your home mortgage)? What if I were to tell you that you could do
this without making any additional principal payments? What if I were to tell you that you
could accomplish this without changing your spending habits? Does this sound too good to be
true?
I described this mortgage acceleration program as HELM because it allows the homeowner to
take the helm of his homeownership and steer it in the direction and pace he finds that meets
his needs and comfort level. It is indeed possible to pay down your mortgage much earlier than
the previously described mortgage acceleration techniques if you can answer “yes” to each of
the following questions.
1.
2.
3.
4.
Do you have sufficient equity in your personal residence?
Does your credit score allow you to obtain a HELOC (home equity line of credit)?
Are you financially disciplined?
Do you have other liquid, non-retirement financial resources that you can draw upon if
needed?
If you answered “yes” to all of the above questions, you are an excellent candidate for the HELM
program. Let’s take a closer look at these questions.
Sufficient equity will likely vary by lender. What is considered sufficient equity today is quite
different than most lenders thought was sufficient equity a couple of years ago before the real
estate market bubble burst. Let’s assume that you purchase a $300,000 home today and you
have a $100,000 mortgage on your property. You have $200,000 worth of equity in your home.
Would a lender be willing to extend you a $50,000 HELOC today? Likely the answer is “yes.”
Do you have a good credit score? When issuing a HELOC, most banks will verify the source and
amount of your monthly income, your credit score, and how much equity you have in your
personal residence by subtracting the outstanding mortgages on your property from the
property’s market value. Some lenders will require that a market appraisal be done on your
property; other lenders may look at comparable sales.
By financially disciplined, the homeowner needs to have the time and discipline to manage his
financial affairs. The homeowner also needs to have a household budget where after paying the
monthly expenses the homeowner has an amount of money left over each month.
Life is full of unexpected events. When recommending the HELM plan to our clients, we do not
want them to implement a plan that can create financial hardships for them should life-changing
events occur. We recommend that our clients have sufficient liquid, non-retirement funds to
cover those unexpected life events.
HOW DOES THE HELM PROGRAM WORK?
The HELM concept is relatively simple to implement and easy to comprehend. Earlier when we
discussed mortgages and how mortgage interest was computed, we discussed that interest is
paid in arrears and is computed daily. Understanding how interest is computed is critical to
appreciating the HELM concept. Everyone hopefully understands after reading about the
6
alternative mortgage acceleration techniques that if a prepayment of the principal mortgage is
made, the total interest paid on the mortgage loan is reduced and the mortgage is paid off
earlier. If these are not understood, that section of this paper should be reread before
proceeding.
Let’s now assume that the homeowner has a positive cash flow each month of $500 (bi-weekly
salary income (net of taxes) of $2,500 less monthly expenses of $4,500). The homeowner
deposits his paycheck every two weeks in his checking account and pays all of his monthly
expenses on the last day of the month. The checking account pays a very dismal rate of interest.
At the end of each year, the homeowner’s checking account balance increases by $6,000 ($500
times 12) and the homeowner transfers that $6,000 to a savings or certificate of deposit.
Let’s further assume that the homeowner obtains a HELOC from his friendly banker. The
homeowner writes a check from his HELOC for $5,000 and uses that money to prepay his
personal residence mortgage. We all realize that the prepayment of the mortgage will reduce
the homeowner’s total interest payments and accelerate the payoff of his mortgage. “Ahhh”
you say, but all the homeowner did was to decrease his primary mortgage by $5,000 and
replace it with a home equity loan of an equal amount. His total debt balance remains
unchanged. Furthermore, you may have a situation where the HELOC interest rate is greater
than the primary mortgage rate and you would argue that the homeowner may be worse off.
How does the HELM plan benefit the homeowner?
Our financially disciplined home owner has taken steps to have his employer’s pay checks
directly deposited into his HELOC account (the lender allowed this) rather than his checking
account. When the checking account was used, the homeowner had $2,500 deposited into his
checking account every two weeks and hardly earned any interest on these deposits. Now the
$2,500 is deposited directly into his HELOC every two weeks. Thus, the first $2,500 paycheck
deposit immediately reduces the outstanding HELOC balance by $2,500. Since the HELOC
interest is computed on a daily basis, the homeowner receives an immediate interest expense
benefit. When the second salary deposit is made, the homeowner’s HELOC balance is again
reduced. Since the homeowner pays his monthly expenses at the end of each month, the HELOC
balance will increase at the end of the calendar month. Whereas the homeowner’s checking
account balance increased $500 each month and earned little interest, that $500 is now paying
down the HELOC loan and is thus “earning” a much higher rate of interest. The homeowner will
continue this practice and find that after ten (10) months, the HELOC loan has been fully paid
($500 per month times ten months equals $5,000, the amount of the HELOC loan).
What does the homeowner do after the HELOC loan is paid off? Yes, he borrows another $5,000
from his HELOC and uses that money to pay down his primary mortgage. The homeowner can
continue with this strategy indefinitely.
ADVANCED HELM RETIREMENT STRATEGY
Since the purpose of this paper was to educate you about the HELM strategy, I do not wish to
deviate far from that mission. However I do want to mention that the HELM plan can be
implemented along with other financial planning strategies. For those homeowners who want to
7
accelerate the pay off their mortgage but realize that their home equity is earning a zero rate of
return, here is a retirement strategy for them to consider. Rather than using 100% of the money
budgeted to accelerate the mortgage pay off, only use half of that money and use the other half
to purchase a cash value life insurance policy. Cash value life insurance policies may be the best
after-tax, tax-favorable wealth-building tools available. If properly structured, the money in
these policies will grow tax-free and can come out income tax-free as a source of retirement
funds.
IS THE HELM PLAN FOR YOU?
As with most financial planning strategies, the answer is dependent upon the homeowner’s
objectives, risk aversion, income tax bracket, financial goals, and alternative investment
strategies just to name a few considerations. Over the years, we have found that it is important
to understand our clients’ overall financial objectives and to make sure that each action plan
implemented fits within the overall strategy. When clients implement specific strategies without
considering their overall financial objectives, at times the implemented strategy does not fit
within the overall strategy. This is where a CPA firm that specializes in advanced tax planning
and wealth-building strategies can be of enormous value to the homeowner. When Keystone
Financial Solutions, P.C. analyzes this strategy for our clients, we compare the interest savings of
the accelerated mortgage strategy against the lost tax deductions (mortgage interest is an
itemized tax deduction on Schedule A of Form 1040), the after-tax rate of return earned on
alternative investments, and if alternative retirement strategies make sense.
SUMMARY
In summary, I hope that this paper has advanced your understanding of how mortgage interest
is computed and the traditional mortgage acceleration techniques available to you, and
satisfactorily introduced you to the HELM plan. For those homeowners whose sole objectives
are to pay off their mortgage as soon as possible to reduce the amount of interest paid over the
life of the loan and to own their homes free of debt as soon as possible, you now understand
how the HELM plan works and if it better suits your financial goals.
Keystone Financial Solutions, P.C. is a CPA and financial consulting firm that specializes in
providing business owners and individuals with advanced tax and financial planning strategies to
minimize income and estate taxes, preserve our clients’ wealth, and to enable our clients to
fulfill their retirement goals.
The author of this paper, Frank Haarlander, is a certified public accountant and a co-founder of
Keystone Financial Solutions, P.C., a public accounting firm. His educational background includes
graduating from Rutgers College with a BA in Business Administration, a MBA degree from the
Rutgers’s Professional School of Accounting, and a masters in tax degree from Villanova
University’s Schools of Law and Commerce.
Frank’s experience includes serving as a Tax and Audit Attest Consultant for Price
WaterhouseCoopers and as the Vice President of Tax or Director of Tax for major corporations
8
and their subsidiaries, including General Electric Capital, Time Warner, Lukens Steel, and
Colonial Penn.
Frank has held Certified Public Accounting certificates from the States of Pennsylvania and New
Jersey. He is a member of the American Institute of CPAs, the Pennsylvania Society of CPAs, and
the national Society of Accountants. He is a certified Six-Sigma “Green Belt” and has held the
Certified Asset Protection Planner (CAPPTM) and Certified Wealth Preservation Planner (CWPPTM)
designations and is a former state representative for the Asset Protection Society. He is a
former member of the Philadelphia Chapter of the Tax Executives Institute where he held
various executive offices and served on its Board of Directors.
His contributions to the community include lecturing as an adjunct instructor at undergraduate
accounting and graduate tax programs of local colleges and universities, speaking before the
Chamber of Commerce and business associations on various tax and business topics, and
publishing various tax articles, whitepapers, and is the author of a forthcoming book titled “The
Blueprint for Financial Success” for small business owners.
Should you have any questions or wish to schedule an appointment to address your individual
situation, please call me at 610-594-2601.
ACKNOWLEDGEMENTS & FOOTNOTES
Acknowledgements: The author wishes to acknowledge the contributions of F. Bryan
Haarlander, CCPS (Certified College Planning Specialist). Bryan created the Excel worksheets that
were used to compute the monthly mortgage payments and the monthly amortization
schedules under various scenarios. The author also wants to thank Bryan for editing this paper
and making meaningful suggestions.
Footnotes:
1
http://www.freddiemac.com/corporate/buyown/english/mortgages/what_is/
2
The author used information found on the website for Mortgage-X (www.mortgage-x.com) to
compute the total interest paid, interest savings, and the accelerated loan payoff for certain
traditional methods of accelerating mortgage payments.
9