Mortgage term - Which is right for you?

Adjust Your Mortgage Term to suit you, not the bank

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, or mortgage term, over which you pay back the loan.

For example, if you borrow $200,000 with a mortgage term of 30 years at a rate of 5%, 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 month into the mortgage, you'd cut 10 years off the mortgage term - 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 $1074 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 with a mortgage term of 20 years from the interest on a mortgage with a mortgage term of 30 years. What you need to do is calculate the Present Value of each mortgage.

The Present Value of a mortgage with a mortgage term of 30 years, with repayments of $1074 at a 5% interest rate is $200,066.

The Present Value of a mortgage with a mortgage term of 20 years, with repayments of $1320 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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