The faster you pay off your mortgage the less interest you pay to your lender and the more equity you build in your home.
Once your mortgage has been paid off entirely then the money you would otherwise spend on repayments is directed towards new investments.
In very simple terms this is the concept of wealth creation.
Let’s take a closer look…
Mortgage acceleration to grow wealth
In scenario 1 above you have a $500,000 loan with a 4.5% interest rate and a 30 year term. Your repayments are $2,534/mth and the total amount of interest you pay is $412,000 over the 30 years of the loan.
In scenario 2, everything is the same only you pay an extra $466/mth (total $3,000/mth instead of $2,534/mth).
As illustrated in the diagram, making the larger monthly repayments reduces your loan term by 8 years (from 30 years to 22 years) and also results in $126,000 less interest paid to the lender.
In year 23 there’s no loan or loan repayments anymore so you will have more disposable income. You could use this income to buy a car or another property or to invest in shares.
You don’t have to wait until year 23 to buy the second property though. Even before then, so long as there’s enough equity in your first home (ie. you have paid down enough of your original $500,000 principal) banks will be willing to lend you more money to buy your second property (or to invest in other things).
This is achieved via a process called refinancing which I’ll discuss further in a separate post.
The amount of equity you have in your property is simply your property value less your loan balance.
Equity value = Property value — Loan balance
When you increase your equity you grow your wealth. And as you can see via the formula you increase equity by either:
a) paying down your loan faster; or
b) having your property value increase
(of course the reverse is true as well, your equity will be reduced if the value of your property falls)
So the questions to ask then are how can you pay off your loan faster, and what are the risks?
Here are four simple strategies, along with a few considerations on the flip side.
Strategy 1. Increase your mortgage repayment amounts
Pros: This is the example we started off with. By increasing your monthly payments from $2,534/mth to $3,000/mth your loan term reduces by 8 years and you save interest of $126,000 over the life of your loan.
Cons: By making higher monthly payments you’ll have less disposable income each month to spend or invest elsewhere. Sometimes you have to make sacrifices to get ahead but just realise this may negatively impact your lifestyle. What are your living expenses?
Strategy 2. Increase your mortgage payment frequency
Pros: Consider making fortnightly repayments on your mortgage instead of monthly repayments. By making 26 half payments instead of 12 full payments you end up making an extra one month’s worth of repayments each year. Using the numbers from the example above, instead of paying 12 x $3,000/mth = $36,000/yr you would pay 26 x $1,500/mth = $39,000/yr. This strategy would enable you to further reduce your loan term by an additional 2 years and 10 months (from 22 years down to 19 years and 2 months). Magic!
Cons: From a cash-flow perspective this is only possible if you have access to funds on a fortnightly basis. Also make sure your lender doesn’t charge you extra for making more frequent payments.
Strategy 3. Make extra lump sum payments
Pros: Making an extra lump sum payment especially during the early years of your loan also enables you to get your balance down a lot faster. Is there a holiday you could forgo or might that new car wait a bit longer?
Cons…
a) Unexpected expenses. Unless you hold onto enough savings, large lump sum payments make it more difficult to afford unexpected expenses should they arise down the track. For example without the buffer could you continue paying your mortgage if you lost your job or if you were forced to stop working for a while?
b) Opportunity cost with respect to other investments. Australian house prices have shown strong capital growth in recent years however historically they have underperformed the share market. Might you be better off buying shares rather than making a large lump sum mortgage repayment? Diversification can be a sensible strategy in its own right.
c) The risk of more expensive borrowing. Interest rates may rise in the future and they are also higher for personal loans and credit cards than they are for home loans. So if large upfront payments mean you have to borrow again in the future, be mindful that this may be more expensive from an interest standpoint.
Strategy 4. Utilise your offset account
Pros: If you’ve got a mortgage offset account it’s basically a savings account where the interest you earn reduces (or offsets) the interest charged on your home loan. By reducing the amount of interest you pay a larger part of each repayment goes towards reducing your loan principal, which of course means your loan gets paid down faster.
Cons: An offset account is great if you’ve got a lot of money in it. But sometimes lenders charge you higher interest rates on your mortgage for the privilege of having the account. So if you don’t have a lot of savings, and you’re not offsetting any interest, then it’s probably a waste.
I’ll discuss the tax implications of paying your mortgage off quickly in a separate post but if tax benefits from negative gearing are important to you then these strategies may be counterproductive.
In summary, you can grow wealth by paying your mortgage off faster but be mindful that’s it’s not always the right thing to do.
If you’ve got any questions feel free to ask via the comments box below.
