Lately, I’ve been looking for a way to earn more money on my savings. The 1.25% I’m getting right now just isn’t cutting it. But, I’m very risk averse, so I’m not sticking the savings in the market. And some of the savings I’m earning interest on will be needed in less than a year, so I can’t tie the savings up in a long-term CD for example.

A buddy of mine has a similar problem. He’s a partner in a business and so has to keep a large amount of cash on hand to pay his quarterly taxes. So he was also looking for a way to get a better return on these savings, and he stumbled upon something called “Mortgage Cycling”.

I had read about this a long while back, but it wasn’t something I could take advantage of at the time. But circumstances have changed, and I’m now in a position to put this strategy into effect for my own savings. Here’s how it works.

**Mortgage Cycling**

First, you must have a mortgage, and it must be one that you actually need to have. Meaning you couldn’t afford to live in your house without the mortgage. So this isn’t for people who have paid off their house. They’re already in a better position than this.

Second, you must be able to get a Home Equity Line of Credit, or HELOC. The requirements for a HELOC (at least in Texas) are that you must have more than 20% equity in your house. Or stated otherwise, your mortgage plus the HELOC cannot be more than 80% of the home’s market value. (This was the circumstance that prevented me from taking advantage of this in the past.)

Third, you must have some amount of money left over at the end of the month. This would be the savings you want to earn a higher return on. As part of our budget, my wife and I set aside money each month for large annual or bi-annual expenses like car insurance, home insurance, life insurance, real estate taxes, Christmas gifts, and IRA deposits. We also have categories that we stash money away in for when we want or need to spend it later like car expenses, home expenses, medical/dental expenses, pet expenses, entertainment, and vacations. So in any given month we have up to $2k that basically goes in a bank account to wait until it’s needed.

Now, the key to understanding this strategy is that you pay interest on your current mortgage balance each month. If you can lower that monthly balance, even temporarily, then you’ll save money by not paying interest on the amount that you lowered it by. And that saved money is equivalent to making a higher rate of return on that money.

So say you owe $100k on your mortgage and your annual interest rate is 6%. That means for the current month, you would owe the bank ($100k * 6%/12) $500 in interest. If you paid an extra $2k against your mortgage, then your balance would be $98k, and you’d only owe $490 in interest. You’d have saved $10. Which is equivalent to earning an annualized 6% on the $2k.

Next month, you put another $2k against the mortgage, and you save another $10 per month. So this month you saved $20. With the $10 from last month, that’s $30 total so far for the year.

Then as the months roll by, $30 becomes $60, $60 becomes $100, $100 becomes $150, and so on up to $780 total for the year in month 12. Month 12 is when I need some of the money that I’ve been saving to pay for real estate taxes, insurance, gifts, and IRA deposits.

At this point, I can take a draw against my HELOC, and pay those expenses with that. So now I have my mortgage, plus a debt on my HELOC to pay off. The HELOC will probably be a variable rate, or if not a variable rate, then a fixed rate which is higher than my mortgage. So in coming months, my $2k deposits will go against paying off the HELOC until it’s paid back down to zero, and then the $2k deposits will go against my mortgage again.

Note though, that I’m not pulling out the full $24k that I saved up over the year. There were those other non-annual expenses (car, home, medical/dental, etc) that I didn’t necessarily need to pull money out for. So those other savings are continuing to “earn” the 6% interest.

So where is that $780 then? Well, you’re still making your regular mortgage payments, so the $780 actually went to pay down the value of your mortgage. So not only are you making a better return on your short-term (and/or long-term) savings, you’re also paying off your mortgage faster.

How much faster? Well, paying $780 on a $100k mortgage each year is like making an extra mortgage payment each year, which would pay off the mortgage in about 25 years as opposed to 30 years.

**Risks**

There are a few risks, but they are remote in my opinion.

One possible risk is that your HELOC could be canceled. Maybe the bank goes out of business, or some other unforeseen circumstance occurs and your HELOC is not accessible. If that happens, then you wouldn’t be able to immediately get the extra funds back. I see this as very unlikely to happen. If it did happen, then I’d borrow money some other way at the time, either opening another HELOC with a different bank or borrowing on a credit card, or whatever.

Another possible risk is that your variable rate HELOC’s interest rate could shoot up. In this case, I would just pay down the balance on the HELOC as fast as possible. And if rates were really going up, then savings rates would also be going up, and I might consider switching to putting my savings in a savings account again.

**Where to get a HELOC**

So the only other question my buddy had was where to get the HELOC. My suggestion for any loan or savings product is to always check the credit unions in your area first. They have a natural advantage against the banks in that they pay less taxes. So the banks have to charge higher fees to make the same profit and provide the same service as the credit union.

It used to be kind of difficult to join a credit union. You used to have to satisfy some fairly tight restrictions to join. But it seems like lately anyone can join any of them by jumping through some fairly easy hoops. For example, in my area, there’s a place called A+ Federal Credit Union. I think it was originally a teacher’s credit union. But under the requirements now, you can get in if you have a kid in any of the schools around here. And if that doesn’t get you in, then you can donate $10 to a charity fund they have for supporting teachers.

So basically, if you pay $10, you’re in. They charge 1% of the Line of Credit Limit, plus about $150 to establish the HELOC. The current interest rate is 4.625% according to their webpage.

Another Credit Union in my area is Austin Telco FCU. They don’t advertise their HELOC’s very well…or at all really, but they pay all closing costs, so establishing the HELOC is free. The only catch with theirs is that you can only make 6 draws on the HELOC for the life of the HELOC. Since I’m only planning on doing 1 per year, that might work for me. They also say you can only open one HELOC per 12 months. So worst case, I just close the HELOC after 12 months and open another to get another 6 draws on the HELOC. Theirs is also variable, and it’s 4.5% right now.

And still another Credit Union is University Federal Credit Union (UFCU). They have a fixed rate 6% HELOC, and the closing costs are not to exceed 3% of the Line of Credit limit.

So there’s lots of options for establishing the HELOC and getting this strategy going.

**Wrap Up**

So there you go. A way to get a higher return on your short-term savings by paying off your mortgage faster and without tying up your money long-term.

**[EDIT] Postscript**

My buddy pointed out that there is another way to implement this strategy that hadn’t occurred to me.

His implementation of the strategy would be to replace his mortgage with a HELOC. So he would get a HELOC for the amount of his current mortgage, and then pay off his mortgage. This would likely need to be done all at once by the bank as part of the closing. But as long as you owe less than 80% of the value of your house you should be able to do it.

For that particular implementation, you would probably want the interest rate to be fixed because you’re likely going to have a large amount of debt sitting in the HELOC. The UFCU 6% fixed rate HELOC would work for this. The website says they have 5 to 15 year terms. So if you had less than 15 years left on your mortgage, you could switch to the HELOC and not pay off the debt on your house any faster than currently. Getting into specifics though, since the UFCU HELOC has 3% closing costs, you would need to make sure that you’re going to use this strategy to save at least that much.

I played with some spreadsheet numbers quite a bit, and here’s what I found out…

Of course, if your new HELOC interest rate is less than your mortgage interest rate, then you’ll save money. Make sure to figure in the closing costs to the amount you would save in interest to make sure you’re saving money overall.

If your new HELOC has a higher interest rate than your mortgage, then it gets a little less clear. The scenario I worked up was if your mortgage rate was 5% fixed and your new HELOC rate was 6%. And you planned to make extra payments throughout the year, and then pull out all the extra payments at the end of the year.

If your mortgage was $100k, you would need to make extra monthly payments of about $2500, and then pull out $30k at the end of the year. This would save you just over $3k for the life of the mortgage/HELOC, and so you would only just barely be making up for the closing costs on the HELOC.

If your mortgage was $50k, you would need to make extra monthly payments of about $1750, and then pull out $21k at the end of the year. This would save you just over $1.5k for the life of the mortgage/HELOC, and so you would only just barely be making up for the closing costs on the HELOC.

If you don’t use this implementation of replacing your mortgage with a HELOC, and instead just augment the current mortgage with a HELOC, like in my original explanation above, then what you are really doing is paying off your mortgage faster. And that’s where the savings come from. This happens to work out for me, but it’s not going to be what everyone wants.

Interesting post. Correct me if I'm wrong. If you paid 12000 etc a year on your home, then at the end of the year pulled out the full 12000 from your HELOC at a higher interest rate, then wouldn't you always be paying your HELOC off and never contributing to your mortgage? Sure you get the initial interest from the first year, but it would seem over time the HELOC interest rate would eat that up.

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That's correct. If your HELOC rate is higher than your mortgage rate, and you plan to pull all the extra mortgage payments out every year, then you would probably lose money.The gains come from either having a lower HELOC rate (like because it's variable…my mortgage rate is 4.652% fixed, but my HELOC is 4.5% variable). Or from having short-term savings that you leave sitting in your mortgage (like I've parked my $10k emergency fund in my mortgage). Or of course you could have both a lower rate on the HELOC, and parked cash.

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But even at a lower variable rate, don't you have the risk that the variable rate will rise before you have paid it off and it could potentially run to a high enough interest rate to take whatever gains you had?

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That's theoretically possible, but not likely for my situation.The HELOC agreement says they can raise the rate a maximum of .5% per quarter. So it could go as high as 6.5% in a year.But the most I'm ever going to pull out at a time would be $10k. Since I have $2k per month that I can put towards this, that would be 5 months of payments. which at most would be 2 interest hikes, or 5.5%.So it could happen that I get stuck paying a bit more interest for a little while, but I highly doubt it will eat up the gains that I've already realized from this.

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I see your point. However, it seems to me that the real trick to making this tactic work is to pay more on the mortgage than you take out in the HELOC. Regardless of interest rate if the amount in the mortgage is large enough it could compensate for the little bit at a higher interest rate in the HELOC. Yet over time if the HELOC is not paid it will eat into your savings. For someone with risk aversion I don't know why you'd risk your emergency fund. Your home value could drop and the bank stop the HELOC, or if the emergency is tapped and you end up using the full amount, your fund is now debt with interest.

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Your questions made me go back and reexamine the strategy and talk to my buddy about how he had planned to use it. I've posted a follow up "Postscript" above that goes through what I found.Basically, what I'm doing is just paying off my mortgage faster, which of course is going to save interest.I'm planning to write a post on risk aversion here soon, so I'll address your questions about risk aversion and the emergency fund in that.Thanks for the discussion!

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