On ‘velocity banking’ (2)
This is my attempt at an explainer, from 2020.
Explain velocity banking, since there’s quite a bit of sales pitches out there, and non-explanations.
First, does it work? It depends.
Does it do miracles? It depends.
It always depends on what your alternatives are.
On the backdrop of a 3.6% mortgage, every payment of principal is effectively investing that money for a 3.6% yearly return!
It is not accessible to everyone. You must have a house and a mortgage. Second, you must have leftover cash each month. Velocity banking is based on you putting your excess cash each month into a repayment of the principal of your mortgage. (This assumes that you have excess cash left over after you pay off all your monthly obligations, including your regular mortgage payment.)
The issue with that is, of course, that while you are paying a lot of your mortgage principal off, you are not saving anything. What if you happen to need the money that you just gave to your bank?
This is where HELOC comes in. Taking out a HELOC allows you to tap some of that principal you paid off back if you need it. Proponents of velocity banking say that you should use your HELOC as you checking account, and pay everything from it, in anticipation of a paycheck, which goes directly to pay off your HELOC.
Magic! Or is it? What you gained is the ability to pay off your principal faster (effectively, you get a 3.6% return on that money because you prevent your mortgage interest from growing as fast as it otherwise would!)
But this is not for free. Now, everything you buy is subject to 8% interest.
Essentially you trade the ability to get money back for the fact that using your money is no longer interest free.
HELOC interest is typically higher than mortgage interest; and typically lower than interest on credit cards. Depending on what you would otherwise do with that money, this may be good for you. For example, if you would otherwise use your credit card, on which you would pay 24% interest, then heloc is probably better.
Remember: you want to have your debts have the lowest possible interest rate.
This is why some inventive folks have thought of using a cycle between HELOC account, credit card and mortgage repayment to lower the amount of interest one carries at any given time. They noted that credit cards would typically give you ~1 month of grace period before the payments are due. This means, effectively, for 30 days you pay 0% interest on that credit.
Since for 30 days your spending is for free, you rack up the debt on your credit card. After 30 days expire, you risk starting to pay 24% interest on that. So you use HELOC to pay this off, and now you are paying 8% interest on that same amount, instead of 24%. Once your paycheck comes in, you pay off the HELOC. Once HELOC is paid off, you start with using the credit card again.
When does this not work? You still may not spend more than you earn, since that racks up the interest.
When does this work? If you are a house flipper, you need money to fund the flip. If you don’t have cash, your alternatives are typically a 12% hard money loan; or a 8% HELOC. And the choice is clear.
When does this not work? If you just want to pay off your mortgage faster, and you make enough money to have a safety cushion, you can pay off directly with cash. This has the advantage that you are not paying interest.