HELOC math fuzziness

[ericbonabike]

Hey folks,

I'm buying a new home.  We are buying a modest 1650 sq ft house (4 bedroom, 2 bath) at a price of 175,000.  We are putting 40k down.  And financing the rest with a 15 year fixed mortgage with a rate of 3.375 annually.

I happened to see a youtube video:
https://www.youtube.com/watch?v=TWh5vBa-jhM


The basic concept is: 
1) Interest on mortgage is computed using a compounding method, and interest is front-loaded on the loan.
2)  If you have equity in your house, you can take out a HELOC.  MMM recommends for "springy debt" to service as surrogate emergency account. 
3) Video above makes a (not great) case which says:  mortgage is compounded.  HELOC interest is simple.  So, take out HELOC, put 100% of that money down on mortgage, and then begin paying your HELOC off, while using your HELOC to pay for all monthly expenses.  The monthly expenses get paid after you get paid, so, your monthly average balance will be a bit lower than the original HELOC loan, ergo, lower total payments.


In my example:  Take a 175,000 house, put 40,000 down.  Mortgage is now 135,000. 
If I get a HELOC for 25,000, my mortgage balance is 110,000.  But we make about 10k a month. 
So, as soon as I get paid, I put 10,000 on that HELOC.  and the balance goes to 15000.  Let's say I spend another 3k that month, and put all on HELOC.  At end of month, balance is 18000. therefore, monthly interest would be lower. 

My gut tells me, this is too good to be true. And to me, it looks like basically using HELOC as a revolving credit card, and 100% of excess money is going to pay down the heloc.  How is that any different than just paying down mortgage aggressively?

[MDM]

The basic concept is: 
1) Interest on mortgage is computed using a compounding method, and interest is front-loaded on the loan.

Mortgage interest is not "front-loaded".  You are always paying the mortgage interest rate on the unpaid balance of the loan.

[AMandM]

In my example:  Take a 175,000 house, put 40,000 down.  Mortgage is now 135,000. 
If I get a HELOC for 25,000, my mortgage balance is 110,000.  But we make about 10k a month. 
So, as soon as I get paid, I put 10,000 on that HELOC.  and the balance goes to 15000.  Let's say I spend another 3k that month, and put all on HELOC.  At end of month, balance is 18000. therefore, monthly interest would be lower. 

It won't be any lower than if you had put the $7000 directly towards the principal on your mortgage. Either way, at the end of the month you owe, and pay interest on, $128k (135 - 7 or 110 + 18).

My gut tells me, this is too good to be true. And to me, it looks like basically using HELOC as a revolving credit card, and 100% of excess money is going to pay down the heloc.  How is that any different than just paying down mortgage aggressively?

Your gut is right, it's not any different. Except, if your HELOC has a higher interest rate than your mortgage, you'd end up paying more interest with the HELOC. Plus, there are usually fees to open a HELOC.

[sol]

Mortgage interest is not "front-loaded".  You are always paying the mortgage interest rate on the unpaid balance of the loan.

My amortization table suggests otherwise.

As the unpaid balance goes down, the percentage of your fixed monthly mortgage payment that goes to pay for interest goes down each month.  That's probably what was meant by "front loaded".

[dandarc]

Mortgage interest is not "front-loaded".  You are always paying the mortgage interest rate on the unpaid balance of the loan.

My amortization table suggests otherwise.

As the unpaid balance goes down, the percentage of your fixed monthly mortgage payment that goes to pay for interest goes down each month.  That's probably what was meant by "front loaded".

Yeah, I'm sure that's what whomever was hawking this idea was getting at, but that's a stupid way to look at it.

The math is simple, absent fees, if the HELOC rate is lower than your mortgage rate, you'll come out a bit ahead with these shenanigans vs. just paying down the mortgage directly. Initially, a portion of the loan will be at a lower rate. It won't be an earth-shattering difference compared to just paying extra directly to the mortgage, but saving, say 1% / year on $25K comes out to $250 / year. Not nothing, but not a whole lot either.

Of course there is no free lunch. The catch is that HELOC rates are almost always variable, so even if the HELOC rate is lower than the mortgage today, will it continue to be? What are you going to do if the HELOC adjusts higher than the base mortgage rate? Better have a plan for that, because if the HELOC rate is higher than the mortgage rate, that costs you money compared to just paying the mortgage. Also note the terms - some HELOC's have introductory rates that look like a good deal at first - as an example a local bank I've used before has a 1.99% rate for 6 months, then 5.5% variable. Not much use for OP's plan, as it would only work on an amount they can pay off in 6 months.

Of course, all of that ignores what is probably the best thing to do - keep that cheap 3.3% fixed rate mortgage as long as possible and invest any extra dollars rather than paying down the mortgage at all. Bonus points for cash-out refinancing in the future when there is enough equity and if rates are still low enough that it makes sense.

[Telecaster]

And to me, it looks like basically using HELOC as a revolving credit card, and 100% of excess money is going to pay down the heloc.  How is that any different than just paying down mortgage aggressively?

It isn't any different.    This strategy keeps popping up and just won't die.   All you are doing is borrowing money to pay off money that you already borrowed.  Since HELOC interest is usually higher that mortgage interest, you actually wind up worse off, when the smoke clears.

[MDM]

Mortgage interest is not "front-loaded".  You are always paying the mortgage interest rate on the unpaid balance of the loan.

My amortization table suggests otherwise.

You think one does not always pay the mortgage interest rate on the unpaid balance of the loan?

As the unpaid balance goes down, the percentage of your fixed monthly mortgage payment that goes to pay for interest goes down each month.  That's probably what was meant by "front loaded".

Perhaps, but irrelevant - except as a way to imply "this weird trick" is something special. ;)