| For years, banks and
financial advisors have been recommending that you pay extra cash
into your mortgage, to 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 $1,074.
Over 30 years, you would actually pay 1074 x 360 (months), which
is $386,640. That's
$186,640 in interest!
If you could find an extra $246 a month, and pay
$1,320 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 $1,074
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.
How does the time value of money affect
our example?
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.
The Present Value of a 30 year mortgage
with repayments of $1,074 at a 5% interest rate is $200,066.
The Present Value of a 20 year mortgage
with repayments of $1,320 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.
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.
Giving your money to the bank
to avoid paying 5% interest means that you can't use that money
to earn 10 or 12 or 15 somewhere else.
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