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