Mortgage Cycling Explained
When many people purchase a home or piece of real estate, they finance it with a mortgage. As they start to make monthly payments on that mortgage, most of the payment goes toward the bank and only a small portion goes to pay down the actual principal owed. Mortgage cycling is a way to pay down the principal of your mortgage at a quicker pace than if you simply made your regular monthly payment.
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Overall Strategy
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The basic strategy behind mortgage cycling is that by making additional payments to principal you will shorten the life of your mortgage loan. How does this happen? Each month when the bank calculates what is owed to them, it is based on a principal amount that you borrowed. After making an additional payment to principal, the amount you owe them is reduced. So the following month when they make the next calculation, more of your money is being put toward principal than it would have if you had not made that extra payment.
Equity
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The result of mortgage cycling is that you will build equity in your property faster than you would if you simply stuck to the payment plan as laid out by the amortization schedule. For instance if you purchased a $100,000 home with 10 percent down, that would mean you owed the bank $90,000. Assuming the property is worth what you purchased it for, you would have 10 percent equity. After the first year of payments, you might have knocked an additional $1,000 off the principal of your loan on a 30-year mortgage. So after one year, you would still only have 11 percent equity. However if you "cycled" your mortgage by just an extra $250 per month, or $3,000 over the course of that year, you would only owe $86,000 and have built up to 14 percent equity.
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Private Mortgage Insurance
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Private Mortgage Insurance, or PMI as it is sometimes referred to, is an insurance which a buyer must carry if he is placing less than 20 percent down on a property. Some lenders will allow you to be released from your PMI obligation once you reach 20 percent equity in the property. With PMI running between a half percent to a full percent, that can save you quite a bundle on your monthly payment. For instance, if you purchased a home for $400,000 with 15 percent down and were required to carry a half percent PMI, that would be $2,000 per year or $166.67 per month. By cycling your mortgage and removing that payment, it will give you more financial freedom to pay down your mortgage even faster.
Time Frame
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Cycling your mortgage will literally shave years off the life of your loan. For instance, say that you had a mortgage of $150,000 that was at 6 percent on a home that was worth $180,000. Your monthly payments would be just under $900 per month on a 30-year fixed loan. Over the course of that loan, you would pay over $173,000 in interest to the bank. However, if you simply raised your monthly payment to $1,000 per month on that same loan, you would shave 7.5 off of your loan.
Downside
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The downside to mortgage cycling is limited because the benefits are so significant. However, for people who rely on a large tax deduction from their mortgage interest, this deduction will shrink and disappear sooner as you cycle your mortgage and pay it off at an quicker rate. Also, for those people who run a tight budget, cycling your mortgage might leave you "cash poor." The trick is to only cycle how much you can comfortably afford without leaving yourself short on cash for other obligations or incidentals. Also, some mortgages might carry a pre-payment penalty. These are in place because the bank wants to make sure that they get the interest payments they are counting on. This does not mean you shouldn't cycle your mortgage, just know that if there is a pre-payment penalty it will be due upon the final payment of the mortgage if you complete it early.
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References
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