In our last episode, I got you started on your path to becoming a Financial Ninja by showing you how the Smiths paid off a $12,000 credit card balance in about six months with the money they were already making and without changing their lifestyle. I explained that with a little bit of a mindset shift and a small change in how you manage your money, you too can quickly eliminate large credit card balances in virtually no time at all. Today I want to show you just how much power the Smiths have created by accessing that line of credit (credit card) differently than they had in the past. This line of credit is becoming a powerful weapon in the Smiths quest to take control of their finances. They are one step closer to becoming Financial Ninjas, and you could be too.
Most People’s Biggest Investment
Homeownership. Owning a home is a big part of the American Dream. It is the goal of millions of Americans. It is the biggest investment many Americans will make in their lifetimes. Many of us were lead to believe that your home is your biggest asset, this is something I believed as well, until I learned the truth. Your house is not an asset, it is a liability. It is only an asset the day you sell it, up until then it is a liability, a fact that wasn’t well understood until the Great Recession in 2008-2009 when millions of Americans found themselves facing that harsh reality. I am not saying that home ownership is bad, on the contrary I think it a goal for which everyone should strive. However, a Financial Ninja doesn’t get into any investment without fully understanding the up and down side of that investment and without knowing all the possible ways to tip the scales in their favor. Owning your home should not be any different.
Asset vs. Liability
A book called Rich Dad Poor Dad by Robert Kiyosaki changed my life long before I realized it had. I don’t remember when I read this book originally, but it wasn’t until years later that the concepts in this book really kicked in for me. I knew when I first read it that it was having a profound effect on me, it put into word many of the thoughts I had but couldn’t vocalize. One item from the book that I do remember understanding right off the bat was Kiyosaki’s simple definition of an asset and a liability. Kiyosaki believes that an asset puts money in your pocket every month and liabilities take money out of your pocket every month. Of course, this is a simplified definition but it is the truth. This concept stuck with me for years. On the surface, this seems like common sense, it is easy to understand. However, thousands upon thousands of people purchase a house, which is a liability by this definition, and believe it is an asset. Your home is a liability because it takes money out of your pocket every month; mortgage, insurance, upkeep and even if it increases in value it doesn’t put any money into your pocket until you sell it. Even if you own your house free and clear it still costs you money every month in taxes. Try to stop paying your taxes and you will soon see who actually owns your house, but that is a subject for another blog.
What does this have to do with Velocity Banking? Well, nothing directly, because even if you use Velocity Banking to pay off your mortgage it will still be a liability. But, as I’ve said before, the Velocity Banking strategy works best with a line of credit and one of the most available lines of credit for the average person is a HELOC (home equity line of credit). The more equity you can create in your home the larger HELOC you will be eligible for. That HELOC will help you to dramatically accelerate your wealth building efforts by allowing you to purchase actual assets; rental real estate for example, that puts money into your pocket every month. Financial Ninjas know that the key to wealth and financial freedom is controlling real, appreciating assets. There are many ways to acquire real, appreciating assets and I will cover many of them in the future. But why not use the equity in your home to give you a head start. So, let’s get down to it, let’s how the Smiths get their mortgage paid down as fast as possible, that’s what a Financial Ninja would do.
Although there are several methods of using Velocity Banking to pay down or eliminate your mortgage we are going to start with the concept of “chunking”. Chunking is simply moving small amounts of your debt from one financial vehicle to another. In this example, we will be moving debt from the Smith’s mortgage to their credit card. “Wait, did he just say that we are going to pay a 6% interest mortgage with a 21% interest credit card?” Yes, that is exactly what I’m suggesting. Remember, amortized interest? That evil method the banks use to makes sure they get paid first and get paid handsomely. Believe it or not, paying 6% amortized interest for thirty years turns out to be more, a lot more, than paying for that same balance at 21% interest on a line of credit like our credit card if you can accelerate the time it takes to pay it off. I can prove it and show you how.
Now before you say “I can’t pay my mortgage with my credit card” I’m going to tell you that it is possible, not always easy, but possible. In future blogs, I’m going to run down several ways to accomplish this, but for now just know that is can be done and other Financial Ninjas are doing just that. Also understand that even though the Velocity Banking strategy works with a credit card it is so much easier to implement with a line of credit. We will cover many of the possible Velocity Banking tools in the future, I promise.
The Amortization Table
We talked about the amortization table in past blogs, if you own a home you were probably given one, or access to one, when you closed on the loan for the property. It is schedule of payments for the life of the loan and it breaks down how much you will be paying in interest and principal for each payment and for the overall loan if paid to term, usually 360 months (30 years). Very few people take the time to read and understand this schedule. We live in a world where the size of the payment is more important than how much we will end up paying over the life of the loan. I can almost guarantee that your mortgage broker and real estate agent spoke only about the payment you can afford during the home purchasing process. By law the mortgage company has to provide you with a Truth in Lending statement at the closing which shows you exactly how much you will end up paying for the new home you are buying, but most mortgage brokers and home buyers breeze by that information as quickly as possible. Besides, we are really excited about buying a new house, we don’t want to know that we will end up paying more in interest than we pay in principal. That’s assuming we don’t refinance, then that interest number could be much, much more!
As uncomfortable as reading the amortization table can be, understanding it is paramount to understanding how Velocity Banking works. The amortization table is going to show us how effective our Velocity Banking efforts are, it will illustrate the progress our “chunking” is making on our mortgage. And most of all it will allow us to calculate how much interest we are not having to pay and, in turn, saving over the life of the loan.
Now, back to the Smiths. They are my fictitious family who will be the basis of all my Velocity Banking examples. Last time we helped them on their journey to becoming Financial Ninjas by coaching them on how to pay off their $12,000 credit card balance in about six months. They’ve decided that they want to attack their mortgage next with Velocity Banking. For our example, the Smith’s just purchased their home and have a $300,000 mortgage at 6% fixed interest for thirty years. They have only made one payment of $1800 (rounded for simplicity) which covers their principal and interest, taxes and insurance are not included in the $1800 because these cannot be affected by Velocity Banking. They have no real equity in the house at this time so they are going to stick with their credit card, instead of a HELOC, as their Velocity Banking tool for now.
The First Chunk
If you recall our credit card example, the Smiths were able to pay off a $12,000 credit card debt in about six months with the money they were already making and without changing their lifestyle. There is an amazing side effect of using Velocity Banking to pay off your credit card debt, your credit score goes through the roof! All of this positive activity on your credit cards improves your credit report data and your credit score. In addition, the reduction of your credit utilization will dramatically improve your score. In a future blog I will cover this in more detail but understand that this activity should create a significant jump in your credit score. So, because the Smiths are becoming Financial Ninjas they called their credit card company and asked for a limit increase, the credit card company was happy to do it and they raised the Smith’s limit to $25,000. The Smith’s should have also asked for an interest rate reduction which they likely would have gotten, but they were thrilled with the limit increase because of how it is going to affect their Velocity Banking efforts.
Since the Smiths were able to pay off $12,000 in credit card debt in about six months, it is fair to say they can now pay off $15,000 in about a year, wouldn’t you agree? That is the “chunk” they are going to work with to rapidly pay down their mortgage. Even though the Smiths now have a $25,000 limit on their credit card they are going to be careful not to use the entire balance to chunk. There are a couple of reasons for that. First, they want to always have a buffer in that Velocity Banking account in case of emergencies. Remember I said that most Americans are one emergency away from financial ruin, having a buffer available can mitigate that risk tremendously. Second, 30% of your credit score is based on what they call your “utilization rate”, which is simply the percentage of the credit limit you are using on your revolving credit accounts. Anything over 30% of your limit starts to negatively affect your credit score. In a perfect world, we would want to keep our utilization percentage under 30% to best protect our credit score but the power of Velocity Banking justifies the temporary hit our credit will take by utilizing a larger percentage of our limit. But let’s not get carried away, 50-70% is about as high as I would be comfortable going, that way we keep our buffer and don’t completely destroy our newly improved credit score.
If the Smiths make a $15,000 chunk payment to the principal of their mortgage on month two of their loan the overall savings are unbelievable. That one $15,000 payment moves them from month two on their amortization table all the way to month forty-six. This results in a $66,000 savings in interest that they now do not have to pay! This happens because of the change in their principal balance and because amortized loan interest is so drastically front loaded. This also knocks 44 months off the life of the loan. Can you imagine not only saving $66,000 but reducing your loan by almost four years just by making one, $15,000 payment? Hard to believe but it is true, math does not lie. Take a look at the amortization table below to see what I mean.
If you look at month two you’ll see that the principal balance is $299,701 so if you make a $15,000 principal payment you will bring your principal down to $284,701. If you scan down the “beginning balance” column you will find that on month 46 the beginning balance is $284,970, this is approximately where your $15,000 chunk has moved you on the amortization table; the numbers are not exact but they are close enough for Ninja math. Essentially you will never make any of the payments between payment two and payment forty-six which means you will never have to pay the interest for those payments. Let’s do the math, forty-five monthly payments (payment two through payment forty-six) at $1800 per month equals $81,000, minus the $15,000 which goes to principal equals $66,000 in savings (45 X $1800 = $81,000 – $15,000 = $66,000). The results are so drastic because in the early stages of the loan the principal portion of the payment is so small that even a relatively small “chunk”, like $15,000, can have a profound effect on the overall loan.
Now the Smiths just need to follow the Velocity Banking principals they have learned to pay that credit card back down to zero. This should take approximately nine to ten months if they stick to the rate they paid down the original credit card balance. If an emergency comes up they deal with it using the buffer balance they left available on the credit card. Maybe it slows down the rate at which they pay the credit card down but that’s ok, they are still making incredible forward progress.
But Wait, the Credit Card Charges 21% Interest
Yes, there is a 21% interest rate on the credit card balance of $15,000. As I illustrated in the credit card example, that 21% simple interest rate on the credit card balance is very manageable and relatively insignificant compared to the incredible saving this chunk made on the overall mortgage. But let’s calculate that interest so we know for sure. As before, we will use 1.8% a month to calculate the 21% interest, this is being a little conservative on our estimates. The Smiths are not making any more money than in the credit card example and they have not changed their lifestyle, so $5000 in going into the credit card and $3600 in expenses are being paid with the credit card each month; they are attacking the principal of the credit card with $1400 a month. The starting balance of the credit card is now $15,000. Below is a spreadsheet calculating the average monthly interest
|Month||Beginning Balance||Paycheck||Expenses||Ending balance||Average Interest for month|
You can see that month ten essentially pays off the balance and the total interest for the entire time you are carrying the balance is just over $1600. I don’t know about you but I’ll pay $1600 to save $66,000 any day of the week.
The Smiths have been diligent about working the Velocity Banking strategy for about sixteen months now and they have retired their original $12,000 credit card balance and now they have attacked $15,000 of the principal of their mortgage, saving over $64,000 in interest that they will never have to pay and knocking almost four years off their mortgage. And they have improved their credit score, improved their cash flow, and created a better leverage position for themselves in the process. Not bad for our new Financial Ninjas. Their next step would be to chunk another $15,000 to their mortgage from their credit card and then pay that down. Rinse and repeat.
Do it again! Once the Smiths have paid that credit card balance back to zero they will want to make another chunk moving another $15,000 of balance from their amortized mortgage to their simple interest line of credit. Since they have paid their mortgage payments for about ten or eleven months from their first chunk, they are on about month fifty-seven on their amortization schedule. Another $15,000 chunk will move them to about month ninety-two on the amortization schedule. Since they are further into the loan the principal portion of the payment is getting larger. So, the effect of this chunk will not be quite as profound but it will still save them a ton of money. This chunk will move them down the amortization schedule about thirty-five months which will end up saving the Smiths $48,000 in interest they will never have to pay (35 X $1800 = $63,000 – $15,000 = $48,000). If it takes them another ten or eleven months to pay their credit card balance back down to zero they will have saved over $110,000 in approximately two years of Velocity Banking. That is being a true Financial Ninja.
If they continue at this pace, chunking $15,000 every year, they will retire their mortgage in 11.3 years instead of 30. Saving about $238,822 in interest over the life of the loan. What could you do with an extra $240K in your lifetime? How would your retirement plans change if you knew you could pay off your house almost 20 years earlier than you expected? How much better off would you be financially if you had an extra $1800 in cash flow every month, retiring your mortgage early would give that to you.
In my next blog, I’ll show you how the Smiths use this new-found leverage to turbo charge their wealth creation. The Smiths will take the next step in the Financial Ninja journey, they will start to acquire and control real, appreciating assets with the leverage they have created by using Velocity Banking to retire their mortgage.