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Repay Your Mortgage As Slowly As You Want
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 over which you pay back the loan.
For example, if you borrow $200 000
over 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 repayment period - 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 for a 20 year mortgage from the interest
on a 30 year mortgage. What you need to do is calculate
the Present Value of each mortgage.
The Present Value of a 30 year mortgage
with repayments of $1074 at a 5% interest rate is $200
066.
The Present Value of a 20 year mortgage
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.
1howto.com
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