| For years, banks and financial advisors have been | | | | 066. |
| recommending that you pay extra cash into your | | | | The Present Value of a 20 year mortgage with |
| mortgage, to cut down the huge interest amount | | | | repayments of 1320 at a 5 interest rate is 200 |
| and reduce the period over which you pay back | | | | 066. |
| the loan. | | | | The two repayment schemes are exactly equal. |
| For example, if you borrow 200 000 over 30 | | | | The 69 756 'saving' in the interest rate is really |
| years at a rate of 5, your monthly repayments | | | | just the effect of adding the extra 246 a month |
| would be around 1074. Over 30 years, you would | | | | into the repayments - in fact, that 246 a month |
| actually pay 1074 x 360 (months), which is 386 | | | | adds up to 59 040 over 20 years. |
| 640. | | | | What if you took that 246 a month and invested |
| That's 186 640 in interest! | | | | it in, for example, mutual funds? |
| If you could find an extra $246 a month, and pay | | | | If you could get a return of 10 p.a., after 20 |
| 1320 a month into the mortgage, you'd cut 10 | | | | years you would have 186 804. With inflation at 3, |
| years off the repayment period the loan would | | | | that would be worth 102 597 in today's money. |
| be fully paid in only 20 years. Moreover, your total | | | | Why would the banks recommend that you pay |
| payments would be 316 664, saving 69 756! | | | | off your mortgage quickly? Surely the longer the |
| The flaw in this technique is that it ignores the | | | | income stream lasts, the better? |
| time value of money. | | | | The banks love being able to prove that their |
| Everyone knows that money is worth less now | | | | recommendations will 'save you money'. But in |
| than it was when they were younger. If you take | | | | reality, the banks do understand the time value of |
| that 1074 mortgage repayment, for instance, in | | | | money. They know the true value of that extra |
| 30 years time, when the last payment is due, it | | | | 246 a month that you're giving them now, not in |
| would only be worth 437 in today's money. | | | | the future. And the shorter the time you take to |
| A dollar now is always better than a dollar in a | | | | repay the mortgage, the lower their risk, and the |
| year's time, or in 10 year's time. | | | | sooner their money comes back to them to be |
| How does the time value of money affect our | | | | loaned out again. |
| example? | | | | There are some arguments for paying your |
| You cannot simply subtract the mortgage interest | | | | mortgage back quickly for one thing, the quicker |
| amount for a 20 year mortgage from the | | | | you pay, the quicker your equity grows. But you |
| interest on a 30 year mortgage. What you need | | | | should understand that every dollar you give the |
| to do is calculate the Present Value of each | | | | bank now is a dollar that you can't invest. |
| mortgage. | | | | Giving your money to the bank to avoid paying |
| The Present Value of a 30 year mortgage with | | | | 5% interest means that you can't use that |
| repayments of 1074 at a 5 interest rate is 200 | | | | money to earn 10 or 12 or 15 somewhere else. |