Unfortunately, there are many people out there that have not done any financial calculations on how to pay down a mortgage and often have to rely on bankers to do the calculations for them. You are literally asking the fox to guard the hen house when you put yourself in that situation. It is the objective of the bank to get as much money out of you possible. Most people allow the bank to do exactly that by giving the bank your personal income details which allows them to come up with a payment plan for you which maximizes their profits. It is imperative that you do these calculations on your own before going to the bank to know what exactly you are getting into.
I have done some calculations today to get a general understanding of what a mortgage payment plan looks like and how much money will it take to pay it down in the long run. The results are startling because I have found that a $200 difference in your monthly payment can make a a $100,000 difference on the total amount of money spent paying down the mortgage. Yes, the results I present here can save you over $100,000!
The mortgage calculations have been done in an Excel Spreadsheet and I have made the following assumptions:
Home/Apartment Cost = $250,000
Down Payment = $75,000
Interest Rate = %7.5
Monthly Payment = $1,200~$1,400
Using these values, the initial outstanding mortgage balance is $175,000 and I have done the calculations to determine how much money and how long will it take for you to pay off the loan. I have plotted the results for monthly payments of $1,200, $1,300 and $1,400 and the results mortgage balance vs year plot is shown below.
The graph appears a little blurry but if you click on it, a better resolution version will come up.
The total amount of money paid yearly until the mortgage is paid of was then summed up for each different payment rate and the results are summarized in the table below.
The result of this calculation is very revealing. The $1,400 payment obviously allows a person to pay off the $175,000 loan the fastest at 21 years. By just decreasing the monthly payment by $100, it takes an additional 4 years, by reducing the monthly payment by $100 further, the time to pay off the loan takes an additional 13 years!
The difference between the total amount of money paid also varies greatly with the monthly payment rate. The calculations show that the total payment increases by $45,000 when you pay $1,300/month compared to $1,400/month. The difference becomes staggering when the payment rate drops by only $200 to $1,200/month with a difference of over $130,000. The banks would be more than happy for you to pay $1,200/month and extract more money out of you. A $130,000 difference is very serious money!
The result presented here is particular to this example and used as a reference only to this example. For other cases, I highly recommend that you perform your own calculations to know exactly what to expect at the end. Based on this result, I would be more than happy to save an additional $3/day to for nearly $100/month to save myself $45,000 in the long run. Save more daily and you will save more than $130,000 in this case. The results I present here are very profound and will definitely help you when it comes to saving significant amounts of money.
I should note that also if you borrow more money you also must expect to pay more monthly to have the debt paid off to reduce the amount of interest paid.
5 comments:
The reverse is true as well - if you save $100/mo and can invest it at a rate of 7.5%, after 25 years you'll end up with about $89,000 (with $31,200 invested). The mortgage situation is the same, except in reverse.
The only other real-life implication is that in Canada, interest from mortgages is not tax deductible, so paying off a 7.5% mortgage is much better than earning 7.5% on an investment - assuming a 35% marginal rate, you would need to make 11.5% for that to be an equal proposition.
I guess the point here is that although paying the mortgage is usually a better decision for most people, if you can do better than [mortgage rate / (1 - marginal tax rate)] then perhaps paying the bank a bit less and investing the rest is a better option.
Still, there is a huge intangible benefit to being debt-free, mortgage included.
You bring up a good point in the mortgage vs investing example.
Which also brings me to consider the break even point between either taking that money you have now and investing it vs buying a house. The point is to not take out a very big loan because it leads to large interest fees, so instead you invest the cash in the stock market.
When you have enough cash such that when you make a loan, the interest you pay yearly is less than the amount you pay in rent. By paying off your loan, you are effectively reducing the "rent" from interest.
Also you have to take into consideration the inflation(Which though can not be calculated as the drop of value of the currency isn't predictable).
One can not save money today as one could before because the money is constantly loosing value. If you saved $100 for your retirement in 1945 you are a sucker, the money you saved will be worthless when the time come of retirement come. If you didn't invest in a business that would give you a return or in commodity that can contain the value such as precious metals. You loose, saving money can not be done in the long run thanks to the politics.
So either paying off a mortage or investing is the best idea. However I would recommend never to get a MORTage in the first place. Invest or save and in a few couple of years you will have enough capital to buy the estate you wish for, for far less money and in the meantime rent cheap.
Inflation is a big deal in real estate - or any debt leveraged investment. In the above example, while you would be paying ~$1300/mo in year 0, you'd be paying a PV of about ~$800 in year 25... just from 2% inflation. IOW, if you paid interest over the same period of time, you'd still owe 175,000 (ie: rent at ~1100) and you'd still be paying that amount in year 25. The only difference is that normal rent should of increased by ~1.6 times. What is the gap between having a fixed rent and investing the difference (~$200 in the example above) and then increasing your investment amount by the inflationary amount? I get $209,000, FV, from a quick calculation (7.5% return, 2% inflation, monthly compounding). Inflation eats away at debt and increases asset value.
As Sacha said, the $200 has to come from somewhere - and if you were going to invest the $200 elsewhere, the gap could reverse itself (RRSPs at S&P ~8% leads to a net gain instead of paying down mortgage, for example).
The real lesson is to find the extra $200 somewhere. For the most part, the most important thing is to have a financial plan to figure out the different strategies. A lot of strategies can be used, including interest only strategies, if you are willing to accept the risk.
Thanks for the good points Finn. In this calculation, you are correct that I have not considered the impact of saving money from renting and then investing that cash somewhere for a return then to use it in the mortgage in this calculation. I'll have to update my calculations to account for inflation as well.
As for the $200 coming from somewhere, yes that is true you need to find ways of either making it or saving it. But the calculations in just putting it towards the mortgage will allow a person to save over $100,000k is a very significant impact.
Post a Comment