Velocity Banking

Velocity banking is a debt-payoff routine marketed to homeowners, in which the borrower opens a home equity line of credit, draws a lump sum from it and applies that sum to the principal of the first mortgage, then has their income deposited into the line of credit and pays living expenses out of it, so that the drawn balance is worked back down over the following months, and then repeats the cycle. The same routine is often described in plain terms as using a home equity line of credit to pay off a mortgage, and the two names refer to the same thing.

It is worth saying plainly that "velocity banking" is a marketing label rather than a term of art. No regulator, standards body or professional organization defines it, and it appears in no statute or regulation. What is defined and regulated is the instrument it depends on: a home equity line of credit is open-end credit secured by a dwelling and is governed by 12 CFR 1026.40. So the strategy has to be assessed on arithmetic and on the terms of that instrument, which is what the rest of this page does.

Start with what is doing the work. In any version of the routine, the debt is retired by the household's surplus cash flow, meaning income left after every expense. Nothing in the mechanism creates surplus, and a household without one cannot run it at all: if income does not exceed spending, the drawn balance never comes down and the borrower has simply added a second secured debt. Published guidance on the simpler cousin of this idea makes the same point about biweekly payment plans, where the whole benefit comes from making thirteen monthly payments a year rather than twelve, and can be had by adding one twelfth to each monthly payment for free.

The rate comparison is the core of it. Suppose the borrower draws $10,000 and applies it to mortgage principal. From that moment, $10,000 of mortgage debt has been replaced by $10,000 of home equity line debt, and the surplus cash flow is now retiring the line instead of the mortgage. If the line's rate is higher than the mortgage's, the borrower pays the difference on that balance for as long as it is outstanding. If the line's rate is lower, the borrower saves the difference. That is the whole trade, and it is not fixed in advance, because 12 CFR 1026.40(f)(1) permits the rate on a home equity plan to change with an index outside the creditor's control while a fixed-rate mortgage does not change at all.

The offset promoters point at is real, and it is smaller than it sounds. Because a line of credit charges interest on the balance outstanding day by day, depositing a paycheck into the line reduces the balance from the day it lands until the day it is spent. Over a month, if a household's money sits in the line for an average of half the month, the average balance is roughly half a month's income lower than it would otherwise be, and the interest saved is that reduction multiplied by the line's rate for that period. It is a genuine mechanism. It is also bounded by how much cash genuinely sits idle, which for most households is a fraction of one month's pay, and it competes directly with the rate penalty above.

What the instrument does that a mortgage does not. Three features of a home equity line of credit are load-bearing for anyone considering this, and our home equity line of credit page covers each in detail.

First, the line is secured by the home, so a strategy that runs living expenses through it converts unsecured cash-flow risk into secured risk. A missed month on a credit card is a credit event; a default on a home equity line is a foreclosure risk.

Second, a home equity plan usually has a draw period followed by a repayment period, and when the draw period ends the borrower can no longer draw and the required payment can rise sharply. A routine that depends on redrawing stops working on that date, and the date is in the contract from the beginning.

Third, and most important for a strategy that treats the line as a permanent facility: under 12 CFR 1026.40(f)(3)(vi) a creditor may prohibit additional extensions of credit or reduce the credit limit during any period in which one of six things is true, headed by a significant decline in the value of the home. The Bureau's commentary measures that decline against the borrower's initial equity cushion rather than against the home's value, so a relatively modest fall in prices can support a freeze. The line you are relying on to refill can be withdrawn precisely when a regional downturn makes you want it.

A tax point that is not in dispute. Interest on home equity indebtedness is not deductible as qualified residence interest. IRC 163(h)(3)(F)(i)(I), headed "Disallowance of home equity indebtedness interest", provides that for taxable years beginning after 31 December 2017 the home equity limb of the deduction "shall not apply". Deductibility now depends on the debt being acquisition indebtedness, that is, incurred to buy, build or substantially improve the residence securing it. Draws taken to fund living expenses, which the routine requires, are plainly not that. So a borrower who has been mentally treating the line's interest as tax-favored should stop.

How to evaluate a pitch. Ask what the presenter's arithmetic assumes about the two interest rates, and whether it holds the surplus cash flow constant between the two scenarios it compares. A comparison that sends $1,000 a month through a line of credit in one scenario and nothing extra to the mortgage in the other is not comparing strategies; it is comparing paying extra with not paying extra, and the line of credit is doing none of the work. Ask what happens at the end of the draw period, and what happens if the line is frozen. And ask what the presenter is selling, because software, coaching and courses are the common products in this market.

1. Open a home equity line of credit large enough to cover the intended lump sum plus a working balance.

2. Draw a lump sum and apply it to mortgage principal. The mortgage balance falls by that amount immediately.

3. Route income into the line. Pay is deposited to the line rather than to a checking account, reducing the drawn balance.

4. Pay living expenses from the line, which raises the balance again through the month.

5. Repeat when the line is paid down, for as long as the draw period lasts and the lender leaves the line open.

A hypothetical, and the arithmetic is the point. Marisol has a $300,000 mortgage at 5.5 percent fixed and $1,000 a month of genuine surplus after every expense. Her home equity line charges 8.5 percent variable.

Route A, direct: she sends $1,000 a month to mortgage principal.

Route B, the routine: she draws $10,000, applies it to mortgage principal, and then works the line back down at $1,000 a month, clearing it in ten months.

Over those ten months Route B has $10,000 of debt at 8.5 percent where Route A would have left it at 5.5 percent, and that balance declines roughly evenly from $10,000 to zero, so it averages about $5,000. The rate difference is 8.5 - 5.5 = 3.0 percentage points. The extra interest is therefore about $5,000 x 0.03 x (10 / 12) = $125 over the cycle. That is the cost of the routing itself.

Now the offset. Suppose Marisol's take-home is $4,000 a month and, on average, half a month's worth of it is sitting in the line before expenses draw it out, so the average balance is about $2,000 lower than it would otherwise be. At 8.5 percent that is worth $2,000 x 0.085 / 12 = $14.17 a month, or about $141.70 over the ten months. Two things bound that figure. It assumes the cash would otherwise have sat somewhere paying nothing, so if it would have earned interest in a savings account only the difference between the two rates counts. And interest is only avoided against a balance that exists, so once the line is nearly repaid there is less balance left for idle cash to offset.

So on these numbers the penalty and the offset very nearly cancel: about $125 of extra interest against about $142 of saving, a net benefit of roughly $17 over ten months, on a routine that requires every dollar of household spending to run through a line secured by the house. Change the rate spread and the answer moves in either direction: if the line charged less than the mortgage, both terms would favor Route B, and if the spread were five points rather than three the penalty would be around $208 and the routine would lose. What does not change is that the $1,000 a month is what retires the debt in both routes. All figures are illustrative.

Pros

• It directs attention to the one thing that genuinely accelerates a mortgage payoff, which is applying surplus cash flow to principal.
• The daily-balance interest calculation on a line of credit does give idle cash somewhere useful to sit, and that saving is real if small. It is worth the line's rate less whatever the cash would otherwise have earned.
• A line of credit is revolving, so money applied to it can be redrawn during the draw period, which a mortgage prepayment cannot.
• Making the routine work forces a household to measure its actual monthly surplus, which many have never done.

Cons

• It converts mortgage debt into home equity line debt, so where the line's rate is higher the borrower pays the difference for as long as the balance is outstanding.
• The line's rate is variable and the mortgage's may not be, so the trade can turn against the borrower after it is set up.
• Living expenses now run through debt secured by the home, which raises the consequence of a bad month from a missed payment to a foreclosure risk.
• The draw period ends, after which the borrower cannot redraw and the required payment can rise sharply.
• 12 CFR 1026.40(f)(3)(vi) lets a lender freeze the line or cut the limit on six broad grounds, headed by a significant decline in home value, so the facility the routine depends on is not guaranteed to be there.
• Interest on home equity indebtedness is not deductible as qualified residence interest under IRC 163(h)(3)(F)(i)(I), so the cost is not softened by tax.
• The same acceleration is available by sending the surplus to principal directly, at no cost and with no new lien.