Paying off a mortgage early may not be the best thing to do. One could rather invest the cash or use it to start a business. That’s one argument. Others believe that it could be one of your best investments.
Why pay off your mortgage early in the first place? There are two reasons.
1. The first and most important reason from a financial perspective is that you will save thousands of dollars on home loan repayments by paying a little extra into your mortgage every month.
Suppose a bank grants you a mortgage of $100,000 (R800,000 @ $1:R8) over 30 years at 10% interest. Based on these numbers, monthly loan repayments amount to $878 (R7024 @ $1:R8). By paying exactly $878 every month, your home loan will be settled after 30 years.
However, because you’re paying interest on the loan over and above the $100,000 purchase price, the property will actually cost you $315,926 (R2,527,408 @ $1:R8). That’s more than three times the value of the house. You’ll pay an extra $215,926 (R1,727,408 @ $1:R8).
What difference will making extra payments make?
• If you pay an extra $300 (R2,400 @ $1:R8) a month, you’ll save $141,410 (R1,131,280 @$1:R8) in loan repayments.
• If you pay an extra $500 (R4,000 @ $1:R8) a month, you’ll save $161,638 (R1,293,104 @ $1:R8) in loan repayments.
• If you pay an extra $1000 (R8,000 @ $1:R8) a month, you’ll save $182,618 (R1,460,944 @ $1:R8) in loan repayments.
The more you pay, the more you save.
2. Paying off a mortgage early brings peace of mind. You don’t have to worry about losing your home to the bank if retrenched or unemployed. It may make sense to pay down your loan as you approach retirement. Retiring without any debt is a big bonus for most people. The savings can help with living costs and medical expenses as well.
There is the counter argument, namely that it doesn’t make financial sense to settle your home loan sooner. One could rather earn an income or return investing in a mutual fund for example instead of making extra mortgage payments.
Which option would you choose: Pay extra into a loan that levies 10% interest or invest in a fund that earns a certain return?
A big factor to consider is the return.
Even though you don’t actually receive any income for paying extra into a home loan that charges 10% interest, you will save thousands of dollars. The reduction in total interest expense means that you are effectively saving at an investment return of 10%.
If you opt to invest the money in the stock market where the return is less than 10%, you may earn an income, but it will be at a lower rate than what you would save in interest payments. If the stock market returns more than 10%, it may be a better deal than paying more money into your mortgage.
Now ask, how predictable are the returns?
You can be rest assured that a bank will not willingly lower the interest rate on your mortgage. Interest payments are a bank’s primary source of income. They will remain steady and only change with the federal rate or prime interest rate.
In the stock market, returns are highly unpredictable. They may jump up and down on a daily basis depending on economic conditions. As a result, returns are more volatile.
Therefore, money directed to paying off your mortgage early provides a return on investment that is more reliable and predictable than anything the stock market can offer.
So should you pay off the mortgage early? Here’s a suggested approach:
• What is more important to you: peace of mind or financial return? If it’s the peace of mind obtained from getting rid of all your debt, then make the extra payments.
• If financial return is more important, then weigh up the amount and predictability of the returns. If I find another deal, like a buy-to-let property, that pays a stable return much greater than 10%, you can bet that paying off a mortgage would be the last thing on my mind.