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Text File | 1993-03-16 | 8KB | 127 lines

COMMENTS ON TAPERED ACCELERATIONS & SPLs ---------------------------------------- There are two two financing strategies that can help individuals and businesses alike, namely, tapered pre- payments and skip payment loans. For example, with today's low interest rates, a new mortgage, if it's the right one, may be one of your best money management moves. Many home owners have done exactly that, but all too often, unfortunately, with short-term notes, typically 15 years or less. As a general rule, the short payouts aren't a good idea because they lock the borrower into higher monthly payments with no ability to lower them (short of refinancing, that is). Traditional 25 or 30-year terms are more flexible financing vehicles. The best approach for borrowers who want to speed up ("accelerate") an existing or new mortgage, and one that can actually reduce the effective interest rate, is to prepay against the principal. This is accomplished by adding an extra amount to the regular payment which is credited directly against principal. Unfortunately, most people add the same amount in each payment, and this happens to be a very poor prepayment strategy. Prepayment strategies, especially for mortgages, should consider prepaying unequal extra amounts towards principal. A simple example makes the point. With no prepayment, a 30- year mortgage for $50,000 at 9% is paid off in 360 monthly installments of $402.31 (total interest, $94,832.07). The simplest prepayment strategy, and the one used by most people, is to add the same extra amount each month. If an extra $50 were added to every payment, the loan would be paid off in 237 payments at a savings of $37,900 in inter- est. This strategy yields an effective annual percentage rate (APR) of 8.978%. Over the life of the loan, it prepays a total of $11,850 toward the principal. But significantly better results are obtained using a strategy of unequal prepayments. If, instead, an extra $100 were added to the first 60 payments and $35 to the rest, then the mortgage is retired in only 218 payments, and $45,614 is saved in interest. The effective APR drops to 8.635%, a substantial reduction. And the total prepayment against principal is actually a few hundred dollars less! Still better strategies can be developed by gradually tapering the prepayment amount, but this simple example illustrates the general effect. Another critical aspect of developing a sound prepay- ment strategy is taking into account the effect of interest rate changes. This is particularly important to anyone financed with an adjustable rate mortgage. When, and by how much, the interest is changed will materially affect the performance of any prepayment schedule. Even the best strategy can fall apart because of interest rate fluctuations that weren't taken into account when it was developed. Proper consideration of this issue is a must for anyone thinking of prepaying an ARM. The second borrowing technique I think your readers will find useful is the skip payment loan, which is very effective in leveling cash flow. The essence of an SPL is a payback schedule that includes skipped payments which are prenegotiated by the borrower and lender, usually to reduce anticipated strains on cash flow. An SPL can be prepaid like any other direct reduction loan, so that all the advantages of an accelerated schedule are still available to the borrower if desired. Parents looking ahead to college expenses, for example, can use an SPL mortgage to plan for major cash flow variations years in advance. The best SPL schedules allow skipping any prenegotiated sequence of payments, not just the same ones each year. In the college planning situation, the first skips probably won't occur until many years after the loan begins. SPLs are also useful to individuals with fluctuating income, or who experience cash crunches due to holiday gift-giving, vacation costs, or other predictable expenses. A simple hypothetical shows how an SPL works. Joe and Sue are about to finance their new home with a $100,000, 25-year mortgage at a fixed rate of 9%. They have two children, ages 7 and 5. Expecting that each one will start 4 years of college at age 18, Joe and Sue negotiate the following SPL payback schedule: Year Skipped Payments ---- ---------------- 1-10 none 11 Jul, Aug, Dec 12 Jan, Jul, Aug, Dec 13 Jan, Jun, Jul, Aug, Nov, Dec 14 Jan, Jun, Jul, Aug, Nov, Dec 15 Jan, Jul, Aug, Nov, Dec 16-25 none No payments are missed during the first 10 years of the mortgage and after the youngest is expected to graduate college. During the college years, when cash flow is tighter, the SPL payback is designed to skip mortgage payments when tuition is usually due. Joe and Sue can level their cash flow by planning the skips in advance. The appropriate sequence of skips depends on the specific situation, and whatever schedule is best for the borrower's anticipated cash flow is what should be negotiated. In this case, Joe and Sue's SPL requires regular pay- ments of $896.44 for each month when a payment is due. By comparison, the monthly payment without the SPL is $839.20. Even though Joe and Sue are making larger payments, this particular SPL schedule actually reduces the effective interest rate from 9% to 8.788% per year (the couple saves $4342 in interest over the life of their mortgage!). Tapered prepayments and the SPL are financing tech- niques that aren't restricted to mortgage situations. They can be used for any borrowing scenario, even for very short- term loans, and they are also not restricted to use by individuals. Businesses, especially small ones, can frequently use these techniques to considerable advantage. Seasonal businesses (tourism and construction, for example) find SPLs very useful as a way to level cash flow. Both individuals and businesses should always look at these options when money is being borrowed.