You can take $100,000 off the cost of your mortgage with surprisingly little increase in repayments, at least when compared to the savings.
You probably understand how compound interest affects costs exponentially. But, if you’re like most people, you may not realise how much the total interest cost increases over the loan term. And, you might not know how little the corresponding weekly repayments decrease as you lengthen the term beyond 15 years.
As you extend the loan term of a mortgage beyond about 15-20 years, your minimum repayments tend to level out and, at the same time, your interest costs start to skyrocket.
Why wont your bank or broker show this cost?
It’s normal practice for a bank or mortgage broker to set your mortgage term as long as possible, without illustrating the long term interest costs or discussing the lifestyle impact of being tied to a mortgage for longer.
Why won’t your bank tell you this? The longer you take to repay your loan, the more money they make out of you. As banks sell debt, it simply isn’t in their best interest to help you reduce the mortgage term and save you money.
And your mortgage broker? If you use a traditional mortgage broker who keeps trailing commission, they will be paid for the life of your loan. A huge conflict of interest exists when you discuss loan term with someone who will be paid more the longer you keep your debt.
How much do your repayments increase as you shorten the term?
This graph shows weekly repayments and the corresponding interest costs if you borrow $400,000 at 7% interest over various terms:
As you can see, once you get to 25 years, a small decrease of $38 in weekly repayments costs you over $100,000 in interest over the life of your loan.
What does this interest really cost you?
Think of your income as an asset. If you earn an average of $60,000 from age 20 to 65, you will earn $2,700,000 during your lifetime. Using the example above, if you lengthen your loan term from 15 to 30 years, you will spend an extra $311,068 on interest. This equals 11% of all the income you will ever earn.
What if you borrowed less?
If you are like most people, you will choose to make your repayments stretch as far as possible and borrow as much as your income allows. This gets you into the best possible house to live – or the most valuable investment property. But, it’s worth considering the costs over the long term and the alternative of borrowing less.
To illustrate some other options, let’s simply take the $614 weekly repayment for the 30 year loan in the example above, and show what amount you could borrow over shorter terms:
While most people will still borrow $400,000, it’s worth looking at the interest savings (and lifestyle benefits of being mortgage free sooner) by considering borrowing less. Using this example, spending about $23,000 less on your property does save you over $130,000 in interest by paying your loan out in 25 rather than 30 years.
At least look at the alternatives so you are making a more informed decision.
What about taking a longer term and making additional payments?
Making additional loan payments throughout a longer loan term can have the same affect as a shorter loan. But setting the loan term for a shorter period can provide the discipline you need to get rid of the mortgage sooner. And, if you over commit and find you cant maintain your mortgage repayments at a shorter term, you can reamortise your loan (but get advice first).
Should you save at the same time as payoff your mortgage?
As the interest savings from removing debt often outweigh the after tax return from an investment, depending on your time frames, concentrating on paying off the mortgage before saving for a longer term goal, such as the kids education, could put you ahead overall.
But, paying out debt first isn’t always best. For example, if you are approaching retirement and still have the mortgage to payoff, using extra funds to contribute to superannuation could be more beneficial, depending on your individual situation. As always, you should seek professional advice when planning your savings and debt repayment.
What if you already have a loan with a longer than desired term?
It’s never too late to review your current arrangement. We give independent mortgage advice and can arrange loans without commission (and therefore lower fees, which means you repay your loan faster). Contact me to talk.
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