Financial advisors and banks have been telling the general public for years that they should fork out extra money each month toward their mortgage in order to reduce the time period for paying off the loan and to cut down on the interest forked over.
Borrowing $200,000 over thirty years, for instance, with a 5% APR would create a monthly payment of about $1074. Over the next 30 years, you will actually fork out an additional $186,640 in interest for a grand total of $386,640!
Now, the reason that banks and financial advisors tell you to fork out more is that because if you could fork out an extra $246 a month with a total of $1320 going toward your mortgage each month then you would cut 10 years off your mortgage payment period. Moreover, your total payments would be $316,664, saving $69,756!
Of course, the title of this article is not “Why You Should Hand Over More Every Month” and it is about actually handing over less each month. Now I am to show you why handing over much more money toward your mortgage is not the best move that you can make. The problem with this thinking is that it does not take into account the “time value” of money.
That said, let me first explain why financial advisors and the banks preach what they do before we get into the time value of money. It’s pretty simple when talking about the banks. It’s less risky to them and they make much more money by lending the money to others when you pay your mortgage early On top of that, banks always pick the homeowners that have PAID MORE money toward their mortgage when they decide who to foreclose on because it exposes them to less risk. Contrary to popular belief, just because you forked over much more money toward your mortgage already does not mean that the bank will not target you. Homeowners are actually safer from foreclosures when they OWE MORE money to the bank.When homeowners OWE MORE to the bank, they actually make themselves less of a target and are much safer.
The prime example of this is the Hilton Hotel empire. The Hiltons did not have one property foreclosed on during the Great Depression as others were being foreclosed on left and right even though they fell behind on their payments several times. Basically, since they owed so much money (and still do since they never pay off their properties) they made sure that the banks would not target them.
Financial advisors often tell their clients to go this route and I have no idea why. They know that the banks first target those that have forked over much more money. They also are costing their clients and themselves a ton of lost profit because of the time value of money which I will explain now.
Everyone knows that money is worth less now than it was when they were younger. If you take that $1074 mortgage payment, for instance, in 30 years time, when the last is due, it would only be worth $437 in today’s money.
A dollar today is always worth much more than a dollar a year from now! or 10 years from now! or 100 years from now.
How does the time value of money affect our example?
You can’t just take the 30 year mortgage and subtract the interest that was saved. To truly determine the best choice, you need to calculate the “Present Value” of each mortgage option.
The Present Value of a 30 year mortgage payment of $1074 at a 5% interest rate is $200,066.
The Present Value of a 20 year mortgage with a mortgage payment of $1320 at a 5% interest rate is $200,066.
The two repayment schemes are exactly equal.
In truth, that $246 per month adds up to $59,040 over 20 years so you are not really saving $69,756 but rather about $10,000.
Now, what would happen, for instance, if you took that $246 a month and invested it elsewhere in something safe and conservative like a mutual fund?
Averaging a 10% rate of return, you would have $186,804 (Note: an S&P 500 Index Fund would be an excellent choice as the S&P 500 has average a 10.83% rate of return over the last 50 years.) With inflation at 3%, that would be worth $102,597 in today’s money.
To get even more answers, let’s ask the question we asked before. Surely, the longer the income stream lasts, the better, right? So why would the banks recommend that you pay off your mortgage much more quickly?
The banks love being able to prove (and make it seem like they are only doing it for your benefit) that their recommendations will “save you money”. But in reality, the banks really understand the time value of money. The banks know the true value of that extra $246 a month that you’re giving them now is much greater now than it will be in the future.
There are some arguments for paying your mortgage back quickly – for one thing, the quicker you fork out, the quicker your equity grows. However, you should fully understand that every dollar that you give the bank is a dollar that you cannot invest elsewhere.
I don’t know about you, but I think that its pretty stupid to worry about handing over much more overall interest when that money can easily make you two to three times as much money while still paying off your house. I put my clients into wealth building mortgages every single day that actually enable them to pay off their house in about 14.5 years and walk away with about $60,000 extra for every $100,000 that they initially borrowed!
Finally, many people have a misconception about the wealthy that I want to dispel. Most people believe that wealthy people own their homes completely and do not have mortgages. Most wealthy people, contrary to popular belief, don’t own their own homes without a mortgage because they fully understand that they can invest their money elsewhere and achieve much higher rates of return than they are paying on the mortgage interest in addition to the tax breaks that they receive. Major corporations like Home Depot and Coca-Cola don’t own the land that they operate on and Bill Gates took out a mortgage for his new $65,000,000 home (which he could have easily paid cash for, right?) So, why is Joe Average so eager to pay off his mortgage faster?
Of course the title of this article talks about actually lowering your monthly mortgage payment while building wealth at the same time and I would love to show you how to do exactly that. If you would like to know how to cut your monthly mortgage payment while at the same time build your wealth then please be sure to contact me.
Ed Brancheau is a mortgage financing whiz who can teach you to lower your payments, pay off your mortgage much faster and create wealth. Call him at 310-770-2369 for more info.
- Ed Brancheau