Magic mortgages are actually illusions

A new kind of mortgage can, as if by magic, make a 30-year mortgage disappear in half the time.

That's what readers are telling me, just before asking if it is "too good to be true."

The new mortgage is from Australia. It's called a "line-of-credit mortgage." Instead of making a monthly payment from your checking account to a mortgage company, the line-of-credit mortgage becomes your checking account. Like your checking account, your paychecks are deposited to the account. The monthly cost of the mortgage, interest-only for some period of time, is automatically deducted from the account.

The paycheck deposits bring an immediate advantage. The amount of your mortgage is reduced by each deposit. Since your mortgage interest payment is a fraction of your monthly income, you get to save the interest cost on the difference -- every month.

Marketing materials for line-of-credit mortgages go on to suggest that using this method can get your mortgage paid off in half the 30 years of a conventional mortgage.

That's great magic.

But just as entertainment magic is based on illusion and sleight of hand, so is lender magic.

You can understand the basics by thinking back to the old biweekly mortgage trick. The advertisements for biweekly mortgage programs -- you know, the ones that magically appear in your mailbox whenever you take out or refinance a mortgage -- intimate that dividing your monthly mortgage payment into two payments and paying every two weeks will cut years off your mortgage.

In fact, the real magic has nothing to do with biweekly payments. If you make 26 payments equal to half of your regular mortgage, you'll make the equivalent of 13 mortgage payments a year rather than 12. The real magic is the additional principal payment, not the biweekly schedule.

It is much the same with a line-of-credit mortgage.

Here's an example. Suppose you and your spouse earn $120,000 a year and will net $90,000 of equity when you sell your house. A lender would allow you to borrow about $360,000, so you could pay $450,000 for your new house.

Instead of taking a 30-year mortgage at 6 percent, requiring a fixed payment of $2,158 a month, you take out a line-of-credit mortgage and arrange for your net paychecks, about $7,100 monthly, to be deposited to your new mortgage/checking account. Under the very best circumstances -- where your paycheck is monthly and deposited at the first of the month, but no checks are written until the end of the month -- your deposit will reduce your mortgage balance by $7,100 for the month. This would knock a maximum of $35.50 off the amount of interest you would otherwise have paid that month, if the interest rate was 6 percent. As a practical matter, the interest savings are likely to be less than $27, reflecting the impact of getting paid every two weeks or writing checks during the month.

If you made a constant payment, the maximum possible benefit would be to reduce your mortgage payments from 360 to 344, a savings of 16 months. That's not chicken feed, but it's a whole lot less than saving 10 or 15 years.

Worse, the savings will exist only if the interest rate on your line-of-credit mortgage is the same as the interest rate on your conventional mortgage. Remember, you don't have to pay a much higher interest rate on all $360,000 of mortgage debt to make the interest savings from $7,100 of extra monthly cash disappear.

So guess what?

Line-of-credit mortgages cost much more than conventional mortgages. The simulator on one lender Web site, for instance, shows an APR of 7.72 percent. At the same time, bankrate.com says the national average on a conventional 30-year mortgage is a tad over 6 percent. Do the math, and you'll be paying an additional $6,192 a year in interest for the possibility of saving a maximum of $45.68 a month.

Query: If that's so, where do the claims for saving tens of thousands of dollars in interest and shaving 10 to 15 years off your mortgage come from?

Answer: From large additional principal payments.

When the savings from the loan are illustrated, it is assumed that you will commit a significant portion of the income you deposit into your account -- at least 10 percent -- to loan prepayment.

If we continue the example above, saving 10 percent of income means putting an additional $710 a month toward principal. That's an extra $8,520 a year for this example. If you regularly added that much to the monthly payment on a standard 30-year mortgage, it would be paid off in 16 years and six months. That's a saving of 13.5 years of payments and about $209,000 in interest. Make the same payments to a line-of-credit mortgage, and it will take longer to pay off because you will be paying at a higher interest rate. It will also cost you more in interest because the interest rate on the mortgage will be materially higher than a conventional mortgage.

Bottom line: Line-of-credit mortgages are all about slick marketing. We have to understand what they don't tell us as well as what they do tell us.

Borrowing money is all about two things: interest rates and payments. Some people may benefit from the flexibility of a line-of-credit mortgage, but using them as a vehicle to accelerate paying off mortgage debt is an illusion.

© 2007, Universal Press Syndicate