Normally, banks and financial consultant will advice you to pay
extra money into your mortgage. With this method, it will help
you cut down the huge interest amount and reduce the period over
which you pay back the loan.
For example, if you borrow $200 000 over 30 years at a rate of
5%, your monthly repayments would be around $1074. Over 30
years, you would actually pay $1074 x 360 (months), which is
$386 640. That's $186 640 in interest! What you have to do is to
find an extra $246 a month, and pay $1320 a month into the
mortgage, you'd cut 10 years off the repayment period - the loan
would be fully paid in only 20 years. Moreover, your total
payments would be $316 664, saving $69 756!
The flaw in this technique is that it ignores the time value of
money. Everyone knows that money is worth less now than it was
when they were younger. If you take that $1074 mortgage
repayment, for instance, in 30 years time, when the last payment
is due, it would only be worth $437 in today's money.
A dollar now is always better than a dollar in a year's time, or
in 10 year's time. You cannot simply subtract the mortgage
interest amount for a 20 year mortgage from the interest on a 30
year mortgage. What you need to do is calculate the Present
Value of each mortgage.
First method of repayment: The Present Value of a 30 year
mortgage with repayments of $1074 at a 5% interest rate is $200
066.
Second method of repayment: The Present Value of a 20 year
mortgage with repayments of $1320 at a 5% interest rate is $200
066.
The two repayment schemes are exactly equal. The $69 756
'saving' in the interest rate is really just the effect of
adding the extra $246 a month into the repayments - in fact,
that $246 a month adds up to $59 040 over 20 years.
Let's think this way. What if you took that $246 a month and
invested it in, for example, mutual funds? If you could get a
return of 10% p.a., after 20 years you would have $186 804. With
inflation at 3%, that would be worth $102 597 in today's money.
Why would the banks recommend that you pay off your mortgage
quickly? Surely the longer the income stream lasts, the better?
The banks love being able to prove that their recommendations
will 'save you money'. But in reality, the banks do understand
the time value of money. They know the true value of that extra
$246 a month that you're giving them now, not in the future. And
the shorter the time you take to repay the mortgage, the lower
their risk, and the sooner their money comes back to them to be
loaned out again.
There are some arguments for paying your mortgage back quickly -
for one thing, the quicker you pay, the quicker your equity
grows. But you should understand that every dollar you give the
bank now is a dollar that you can't invest. You then miss
opportunity to invest and a return 10 percent or even 15
percent!
About the author:
Dr. Drew Henry maintains a number of websites about Loans,
including
Small Business
Loan,
Student
Loan, and
Student
Loan Consolidation
