For years, mainstream banks and financial advisors have been recommending that you pay extra cash into your mortgage account in order 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 a of $186,640 in interest!
Now if you could find an extra $246 a month, and pay $1320 a month into your mortgage account, you would cut 10 years off the repayment period - the loan would be fully paid in only 20 years instead of 30 years. Moreover, your total payments would be $316,664 -saving you $69,756! Looks like BIG savings for you right? Not so fast though...keep reading.
You see, the flaw in this technique is that it ignores the time value of money.
The banks, mortgage lenders and other financial types know that money is worth less now than it was when they were younger. 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 (based on current inflation growth).
A dollar now is always better than a dollar in a year's time or in 10 years from now.
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.
Thus, the two repayment plans are exactly equal over time.
Much of this $69,756 'saving' on the interest rate is really no more than the result of you paying the extra $246 a month. That $246 a month for 20 years totals $59,040.
What if you took that $246 a month and invested it in, for example, mutual funds?
If you could get a return of 10% each year, after 20 years you would have $186,804. With inflation at 3%, that would be worth $102,597 in today's money.
So why would the banks recommend that you pay off your mortgage quickly? Surely the longer the income stream lasts, the better right? - wrong.
Banks love being able to prove that their recommendations will 'save you money'. But in reality, and as I stated earlier, the banks have a very good understanding of the time value of money. They know the true value of that extra $246 a month that you're giving them now, and 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% interest somewhere else.
If you're currently following an accelerated payment plan, you may want to have a family and/or financial advisor pow-wow. This meeting should focus on whether or not those extra mortgage dollars can be invested to earn a more positive cash-flow for you instead of your bank.