Many financial professionals recommend paying off your mortgage as quickly as possible. If you can afford it, the wisdom goes, you should choose a 10 or 15 year mortgage term and pay off your debts well before retirement while saving a considerable amount of interest. Borrowers who select a shorter repayment period pay higher repayments each week (or fortnight or month), but less interest over the loan period.
Indeed, if we consider two loans, we’ll see a huge difference in the interest paid over the lengths of the loans. Both of these loans are for $200,000, both are paying a steady 6% interest over the life of the loan, and both are repaying principal and interest on a weekly basis.
Jake’s loan: 30 year term
Interest over the life of the loan: $231,386.80
Tina’s loan: 15 year term
Interest over the life of the loan: $103,427.80
Tina is saving $127,959 over her loan – hardly small change! It’s a great return on the sweat and hard work involved in paying off her mortgage 15 years earlier, isn’t it?
It may surprise you, though, that paying off a home loan early isn’t always the best plan – especially if your goal is to increase your property portfolio. To see why, we need to look at the opportunity cost of those higher loan repayments.
Tina’s loan requires her to spend 112.48 more per week than Jake’s loan. Over a 15 year period, that amounts to $87,734.40 in extra repayments over the loan. Not a bad price to pay for saving $127,959 in interest unless the Tina wants to use that money for other purposes during that 15 years, such as growing her wealth. Many investors would rather have the extra money available for use in creating more wealth – they’d rather use if to fund deposits on further investments or to improve the investments they already own. Still others would rather use the money to build a contingency fund. In fact, Jake is making voluntary extra payments and paying off the principal early, but is reserving the right to revert to the basic repayment amount – he’s got the benefit of the interest savings while retaining flexibility to reduce payments with little fuss.
There are other considerations, of course. Anyone considering taking out a home loan needs to consider their current and potential financial situations. Answering these questions is a good start:
- Why do I own this property? Is it my home, an investment? A retirement plan? A savings scheme to set my children up?
- What repayments can I afford over the whole life of the loan?
- Am I likely to come into some money before the term of the loan is finished? Do I, for example, stand to inherit or will other investments come to maturity?
Talk to an expert – your accountant or a financial advisor – about which option meets your needs.