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Thursday, September 08, 2005

Repay Your Mortgage As Slowly As You Want

For years, banks and financial advisors have been recommendingthat you pay extra cash into your mortgage, to cut down the hugeinterest amount and reduce the period over which you pay back theloan.
For example, if you borrow $200 000 over 30 years at a rate of5%, 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!
If you could find an extra $246 a month, and pay $1320 a monthinto the mortgage, you'd cut 10 years off the repayment period -the loan would be fully paid in only 20 years. Moreover, yourtotal payments would be $316 664, saving $69 756!
The flaw in this technique is that it ignores the time value ofmoney.
Everyone knows that money is worth less now than it was when theywere younger. If you take that $1074 mortgage repayment, forinstance, in 30 years time, when the last payment is due, itwould only be worth $437 in today's money.
A dollar now is always better than a dollar in a year's time, orin 10 year's time.
How does the time value of money affect our example?
You cannot simply subtract the mortgage interest amount for a 20year mortgage from the interest on a 30 year mortgage. What youneed to do is calculate the Present Value of each mortgage.
The Present Value of a 30 year mortgage with repayments of $1074at a 5% interest rate is $200 066.
The Present Value of a 20 year mortgage with repayments of $1320at 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 theeffect of adding the extra $246 a month into the repayments - infact, that $246 a month adds up to $59 040 over 20 years.
What if you took that $246 a month and invested it in, forexample, mutual funds?
If you could get a return of 10% p.a., after 20 years you wouldhave $186 804. With inflation at 3%, that would be worth $102 597in today's money.
Why would the banks recommend that you pay off your mortgagequickly? Surely the longer the income stream lasts, the better?
The banks love being able to prove that their recommendationswill 'save you money'. But in reality, the banks do understandthe 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. Andthe shorter the time you take to repay the mortgage, the lowertheir risk, and the sooner their money comes back to them to beloaned out again.
There are some arguments for paying your mortgage back quickly -for one thing, the quicker you pay, the quicker your equitygrows. But you should understand that every dollar you give thebank now is a dollar that you can't invest.
Giving your money to the bank to avoid paying 5% interest meansthat you can't use that money to earn 10% or 12% or 15% somewhereelse.

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