Non-compounding home loan?

Non-investing personal finance issues including insurance, credit, real estate, taxes, employment and legal issues such as trusts and wills.
Post Reply
User avatar
Topic Author
epicahab
Posts: 254
Joined: Sat Jun 20, 2009 2:29 pm

Non-compounding home loan?

Post by epicahab »

My primary financial goal is to pay off my mortgage so that I can use monthly income for saving and living. I am 7 years into a 15-year loan (6.25%) and have about 60k principal left to go. It's not a big house but I have been paying extra principal along the way.

As I explored various ways to do this, I began to look at the compounded interest payments I was making and wonder why more people (for example, family members or friends) don't offer non-compounding loans for people looking to pay off their house.

I couldn't just have a friend or relative pay off my mortgage and then have me pay them back because the prohibitive gift tax limits them to a gift of 13k per year (in 2009).

Therefore, I wondered about a non-compounding loan at, say, 3 percent, where the friend loans me 60k and I pay them back over, let's say, 3.5 years at 1,428*1.03=1,470.00 per month.

I pay my house off in less than half the time, they get a free 3% each month (which beats most money market funds these days), and I avoid a huge amount of interest.

While I personally might not have an acquaintance who can afford it, I have never heard of anyone doing this...why? Is there a law saying a loan must compound interest?
User avatar
dm200
Posts: 23214
Joined: Mon Feb 26, 2007 1:21 pm
Location: Washington DC area

Re: Non-compounding home loan?

Post by dm200 »

epicahab wrote:My primary financial goal is to pay off my mortgage so that I can use monthly income for saving and living. I am 7 years into a 15-year loan (6.25%) and have about 60k principal left to go. It's not a big house but I have been paying extra principal along the way.

As I explored various ways to do this, I began to look at the compounded interest payments I was making and wonder why more people (for example, family members or friends) don't offer non-compounding loans for people looking to pay off their house.

I couldn't just have a friend or relative pay off my mortgage and then have me pay them back because the prohibitive gift tax limits them to a gift of 13k per year (in 2009).

Therefore, I wondered about a non-compounding loan at, say, 3 percent, where the friend loans me 60k and I pay them back over, let's say, 3.5 years at 1,428*1.03=1,470.00 per month.

I pay my house off in less than half the time, they get a free 3% each month (which beats most money market funds these days), and I avoid a huge amount of interest.

While I personally might not have an acquaintance who can afford it, I have never heard of anyone doing this...why? Is there a law saying a loan must compound interest?
I don't think you understand how most loans work. Perhaps you mean something different than I do by compounding, but I would not characterise the normal mortgage as compounding. Each month, your payment is applied to interest due (based on the principal balance of the loan) and the remainder goes to pay down principal. Therefore, each month's payment has a larger amount paying down principal each month.

Of course you could borrow money from a friend or relative at a lower or more favorable interst rate (if you could find one). Gift tax has nothing to do with it; you would be borrowing money from the friend or relative - it would not be a gift.

I think you are missing some basics of loans and gift tax - unless I am missing something.

The reason you wouldn't get someone to lend you money at 3% is that there is significant risk.

I did the math on a 42 month loan. At zero per cent, a 60,000 loan for 42 months is about 1,428 per month. At 3%, it would be about 1,508 per month. You have a serious flaw in your math. A 3% loan is calculated on the outstanding balance of the loan, NOT on the payment amount.
User avatar
BruceM
Posts: 1851
Joined: Fri Aug 08, 2008 1:09 pm
Location: Manzanita, Oregon

Re: Non-compounding home loan?

Post by BruceM »

epicahab wrote:My primary financial goal is to pay off my mortgage so that I can use monthly income for saving and living. I am 7 years into a 15-year loan (6.25%) and have about 60k principal left to go. It's not a big house but I have been paying extra principal along the way.

As I explored various ways to do this, I began to look at the compounded interest payments I was making and wonder why more people (for example, family members or friends) don't offer non-compounding loans for people looking to pay off their house.

I couldn't just have a friend or relative pay off my mortgage and then have me pay them back because the prohibitive gift tax limits them to a gift of 13k per year (in 2009).
Not sure I follow. Are you comparing a 3rd party loan to 3rd party gifts? When this involves a family member, the IRS could determine it was not a loan, but instead a gift. With friends, it is usually not considered a gift (because friends usually don't usually pay other people's bills for them), but a below market rate loan.
epicahab wrote:Therefore, I wondered about a non-compounding loan at, say, 3 percent, where the friend loans me 60k and I pay them back over, let's say, 3.5 years at 1,428*1.03=1,470.00 per month.

I pay my house off in less than half the time, they get a free 3% each month (which beats most money market funds these days), and I avoid a huge amount of interest.

While I personally might not have an acquaintance who can afford it, I have never heard of anyone doing this...why? Is there a law saying a loan must compound interest?
No, not that I know of. But as I'd mentioned, below market-rate loans would be considered by the IRS to have deemed interest as the difference between the market rate and what you charged a 3rd party for a personal loan. This is unusual, as most individuals (who are not family members) are not so generous with friends. But if they are, the IRS could require you to take the diferrence between what you paid in interest and what you'd pay at market rates and require you to include this as income.

In your case, with a $60K loan balance on Jan 1 of this year and 8 years on a 6.25% mortgage loan, you'd pay about $3,580 in interest this year. If you're in the 20% Fed + State marginal tax bracket and you itemize deductions, you're net interest expense would be .8 * 3,580 = $2,865. That works out to be a simple interest rate of about 4.8% for 2009. Know anybody who would make you a personal loan for less than this? And with each passing year, the amount you'll pay in mortgage interest will decline. For example, in 4 years, your annual net interest will drop to about $1,500.

BruceM
User avatar
Topic Author
epicahab
Posts: 254
Joined: Sat Jun 20, 2009 2:29 pm

Post by epicahab »

Thank you BruceM, those figures make me feel a little better especially when factoring taxes in.

I am definitely aware that the amount of principal I pay increases while the interest decreases.

Just looking for a turbo boost I guess.

dm200, I probably did not use the correct terminology but you understood what I was saying...basically, don't apply the interest to the remaining loan amount but break it up into months and apply a simple 3 percent to each month's payment.

I guess this is so uncommon that it's not done. Maybe I invented a new financial product.
User avatar
dm200
Posts: 23214
Joined: Mon Feb 26, 2007 1:21 pm
Location: Washington DC area

Post by dm200 »

epicahab wrote:Thank you BruceM, those figures make me feel a little better especially when factoring taxes in.

I am definitely aware that the amount of principal I pay increases while the interest decreases.

Just looking for a turbo boost I guess.

dm200, I probably did not use the correct terminology but you understood what I was saying...basically, don't apply the interest to the remaining loan amount but break it up into months and apply a simple 3 percent to each month's payment.

I guess this is so uncommon that it's not done. Maybe I invented a new financial product.
Your "method" of calculating interest has (at least) two big problems:
1. The return is so poor nobody would extend credit on these terms
2. To be in compliance with Truth In lending laws and regulation, the Annual Percentage rate must be disclosed on a standard manner. Your method would not be at all standard.
superdrew99
Posts: 22
Joined: Thu May 08, 2008 8:51 am

Post by superdrew99 »

If I were in that situation I'd roll over that loan to 0% cards, of which there are still a few with no balance transfer fees or capped fees etc.

Open a heloc on your house in case in a year you can't get another offer when the time comes. It will save you $3750 in interest the first year.
User avatar
ResearchMed
Posts: 16795
Joined: Fri Dec 26, 2008 10:25 pm

Post by ResearchMed »

There are formal arrangements that can be made between friends or family members so that they lend you money and you pay them back. (I don't know if Virgin Money is still the name of one of those services.)
These require regular credit checks (usually), but you can make your OWN terms, such as interest rate.

Those are a way to include a 3rd party (handy for the lender if there should be a "collections" problem later, for example).

Or you could just draw up your own agreement.

But usually any arrangement like this would only be beneficial if there were a much higher initial interest rate.
For example, if Person A has 20k in credit card debt at 18% or 23% (or more, these days) interest, and Person B is interested in helping A plus self, then they could do something like have B loan A to pay off the high-interest credit card.
Then A could repay B at some semi-average interest rate, such as 10% or 12% or whatever.

B should be declaring the interest to the IRS, another factor that lowers B's apparent return.
And if it is now a personal loan, I'm not sure if the interest A pays is still tax deductible, if this was for a home mortgage rather than credit card debt.

However, there IS (or used to be) and "assumed" minimum interest rate that would be allowed for something like this (especially if between friends or family members), and if the interest rate was below that, the IRS is likely to consider it (some or all?) a GIFT.

IF my memory serves me (and I'm not having a senior moment), when I last looked this up, that minimum rate was something in the 4-5% range, but that would have been perhaps 2 years ago.

And on the other hand, I think some states still have usury laws, so that it is illegal to pay MORE than a certain amount.

But as already pointed out, given the relatively low interest rate for a home mortgage, it isn't too likely that there would be someone interested in risking that much, for relatively small return. And of course, the higher you offer, the less you are saving, and it would quickly be more trouble than it's worth.

As already suggested, finding that amount of credit on a zero- or very-low-interest credit card these days might be tricky, but it would definitely be one way to save money.

RM
Post Reply