Overpay your mortgage: a simple but sure way to get rich
It's New Year's Day and the thoughts of Money Bloggers everywhere are turning to how to make sure 2007 is the year they get rich!
So I thought I'd cover a simple, pretty much guaranteed (but excruciatingly slow) method of getting rich.
When we think about wealth we think about earning big money. But the man who earns £1,000,000 and spends £999,999 is less wealthy than the man who earns £25,000 and spends £20,000. Wealth is what you get to keep after expenses. We tend to spend a lot of time thinking about how to make money come in, but don't give much thought to the money going out.
For most of us, our biggest expenditure is our mortgages. Most people pay more in interest payments than they do in tax. The true cost of owning a home is in fact directly related to how much interest you pay over the course of your mortgage. Using a crude rule of thumb, you will, over the course of the 25 year mortgage, pay out three times the purchase price of the house - that is a £100,000 home will cost you £300,000 by the time you have repaid all the capital and interest on the loan.
It's a massive amount of money. Therefore a guaranteed way to get richer is to overpay your mortgage, paying down the capital borrowed as fast as you can, because interest is only charged on debt outstanding. In addition, mortgage interest rates tend to be higher than savings interest rates. Here's an example:
Suppose you have a mortgage with interest rate charged of 5.5% and a savings account giving interest at 4%. You have £10,000 in the savings account.The return on the savings account will be as follows:
Gross interest £400
tax at 20% £ 80
Net interest £320
If you used the £10,000 to pay off part of your loan the interest saved would be £550 - clearly a much higher rate of return. The standard mortgage payment has a capital portion and an interest portion. When you overpay, the interest saved also gets paid against the loan as a capital prepayment.
Here's an example:
Monthly mortgage payment: £500
Capital portion: £150
Interest portion: £350
Paying off the £10,000 frees up interest of £550 per annum or £45.80 per month so your mortgage payment now breaks down as follows:
Capital portion: £195.80
Interest portion:£304.20
total: £500
And of course this new extra capital paid will also save interest and so on - this is known as the miracle of compounding.
Your bank will hate this, as it hurts their profits, so when interest rates change, they will try to adjust your total payment downwards so you are not paying off debt so fast.
What if you don't have £10,000 handy to pay against the mortgage? Not a problem, just pay £50 per month or whatever you can spare. You won't notice it making much difference to start with, but the miracle of compounding means that you should start seeing clear benefits in time. Obviously the more you can pay the sooner the loan outstanding drops.
Why is it that people don't do this? It's because it's excruciatingly slow. You pay £50 a month extra against the mortgage, don't see an immediate effect and give it up. Something in the human psyche demands instant results. But stick with it, this is low risk, and the miracle of compounding means that in time, your debt will drop sharply, your outgoings will drop sharply, and you are then free to use the money freed up in any way you want (either save it, or spend it on a better life).
Some things to note:
1. Make sure that your mortgage terms and conditions allow you to make overpayments without penalty. Some mortgage lenders restrict overpayments, because of course you paying off your loan early hurts their profits. If you are looking to take out a new mortgage, check that they allow you to overpay.
2. Only start making overpayments after you have set up an emergency cash fund in a high-interest building society/bank account, which you don't touch. There will always be emergencies where you need ready cash, and you don't want to find that you've paid your last spare penny into the mortgage, where you can't get at it.
3. I am not a financial advisor. Therefore people take advice from this blog at their own risk.
I wish everyone a Prosperous New Year and I hope all readers of this blog reach their financial goals this year.
Update 27th March 2009. Looking back I feel rather proud of this post in the light of what has happened to the global economy. Those who have been paying down their mortgage from 2007 will be sitting pretty with less at risk than those who haven't. However, it's not too late. The sharp cuts in interest rates mean that those who are on tracker-mortgages or standard variable mortgages have seen a sharp drop in their monthly mortgage payments. Use some of this money to overpay your mortgage. Interest rates will not stay low forever - this is a once in a lifetime event (or opportunity). It will never be this easy to overpay a mortgage again. The economy will recover towards the end of the year and interest rates will rise again. For those who haven't prepared, it will feel like whiplash. But if you have reduced the capital outstanding, it won't be as painful.
Related posts
What happens to your mortgage when you are unemployed
How to cope if you are a Buy-to-let landlord
Ways to raise money to pay off debt
So I thought I'd cover a simple, pretty much guaranteed (but excruciatingly slow) method of getting rich.
When we think about wealth we think about earning big money. But the man who earns £1,000,000 and spends £999,999 is less wealthy than the man who earns £25,000 and spends £20,000. Wealth is what you get to keep after expenses. We tend to spend a lot of time thinking about how to make money come in, but don't give much thought to the money going out.
For most of us, our biggest expenditure is our mortgages. Most people pay more in interest payments than they do in tax. The true cost of owning a home is in fact directly related to how much interest you pay over the course of your mortgage. Using a crude rule of thumb, you will, over the course of the 25 year mortgage, pay out three times the purchase price of the house - that is a £100,000 home will cost you £300,000 by the time you have repaid all the capital and interest on the loan.
It's a massive amount of money. Therefore a guaranteed way to get richer is to overpay your mortgage, paying down the capital borrowed as fast as you can, because interest is only charged on debt outstanding. In addition, mortgage interest rates tend to be higher than savings interest rates. Here's an example:
Suppose you have a mortgage with interest rate charged of 5.5% and a savings account giving interest at 4%. You have £10,000 in the savings account.The return on the savings account will be as follows:
Gross interest £400
tax at 20% £ 80
Net interest £320
If you used the £10,000 to pay off part of your loan the interest saved would be £550 - clearly a much higher rate of return. The standard mortgage payment has a capital portion and an interest portion. When you overpay, the interest saved also gets paid against the loan as a capital prepayment.
Here's an example:
Monthly mortgage payment: £500
Capital portion: £150
Interest portion: £350
Paying off the £10,000 frees up interest of £550 per annum or £45.80 per month so your mortgage payment now breaks down as follows:
Capital portion: £195.80
Interest portion:£304.20
total: £500
And of course this new extra capital paid will also save interest and so on - this is known as the miracle of compounding.
Your bank will hate this, as it hurts their profits, so when interest rates change, they will try to adjust your total payment downwards so you are not paying off debt so fast.
What if you don't have £10,000 handy to pay against the mortgage? Not a problem, just pay £50 per month or whatever you can spare. You won't notice it making much difference to start with, but the miracle of compounding means that you should start seeing clear benefits in time. Obviously the more you can pay the sooner the loan outstanding drops.
Why is it that people don't do this? It's because it's excruciatingly slow. You pay £50 a month extra against the mortgage, don't see an immediate effect and give it up. Something in the human psyche demands instant results. But stick with it, this is low risk, and the miracle of compounding means that in time, your debt will drop sharply, your outgoings will drop sharply, and you are then free to use the money freed up in any way you want (either save it, or spend it on a better life).
Some things to note:
1. Make sure that your mortgage terms and conditions allow you to make overpayments without penalty. Some mortgage lenders restrict overpayments, because of course you paying off your loan early hurts their profits. If you are looking to take out a new mortgage, check that they allow you to overpay.
2. Only start making overpayments after you have set up an emergency cash fund in a high-interest building society/bank account, which you don't touch. There will always be emergencies where you need ready cash, and you don't want to find that you've paid your last spare penny into the mortgage, where you can't get at it.
3. I am not a financial advisor. Therefore people take advice from this blog at their own risk.
I wish everyone a Prosperous New Year and I hope all readers of this blog reach their financial goals this year.
Update 27th March 2009. Looking back I feel rather proud of this post in the light of what has happened to the global economy. Those who have been paying down their mortgage from 2007 will be sitting pretty with less at risk than those who haven't. However, it's not too late. The sharp cuts in interest rates mean that those who are on tracker-mortgages or standard variable mortgages have seen a sharp drop in their monthly mortgage payments. Use some of this money to overpay your mortgage. Interest rates will not stay low forever - this is a once in a lifetime event (or opportunity). It will never be this easy to overpay a mortgage again. The economy will recover towards the end of the year and interest rates will rise again. For those who haven't prepared, it will feel like whiplash. But if you have reduced the capital outstanding, it won't be as painful.
Related posts
What happens to your mortgage when you are unemployed
How to cope if you are a Buy-to-let landlord
Ways to raise money to pay off debt
posted by teatreebergamot at 1/01/2007 01:40:00 PM
9 Comments:
Well Said.
Also, get 15 year morgages or 20 years rather than the traditional 30... helps as well!
You are comparing against putting money into a savings account.
But, what about putting it into the stock market which averages much higher returns than savings accounts over the long term?
Even if you do not agree that the returns are potentially higher, the money in stocks is certainly more liquid than the money that goes to paying off a house early.
Maybe a combination of both is ideal.
The psychological advantage of paying off a house early is definitely a good argument for doing that.
Good post, I am always confused when I see people with both savings and debt.
However, when the debt is mortgage, there are other factors to be taken into account which invalidate your thesis.
1) Tax deductions from the interest on your mortgage wipe out the difference between mortgage interest and savings interest. Also, there is often MCCs (mortgage credit cetificates) and other tax benefits.
2) Putting the money you would normally use to overpay into the S&P500 would net you 8-12% a year. Even after taxes, that's about 6-10% a year.
So lets say you have $10,000. paying your mortgage early saves you (assuming mortgage interest rate of 5.5%) $550. However, you could have used $550 pre-tax money to pay that so you really only saved about $358 (generously assuming 35% income tax + other taxes [the US has state tax, Social Security, and Medicare and Unemployment Insurance]), but putting that cash into the market (assuming modest returns of 9%) nets you $720 after taxes.
Hence, you gain 720-358=$362 (3.6%) for putting your money in the market instead of your mortgage)
This is actually called an offset mortgage. In this any money you have in savings or current account is offset against the mortgage debt before the interest is calculated. This is like paying off some of the debt, but you still have access to the money if needed.
Various companies offer products like this.
lkeable: the stock market is risky. Note that the NASDAQ and FTSE100 still haven't reached their 2000 peak, more than six years later. So it's a myth that the stock market will always make you 8%-10% a year for the next 25 years. It may, but may not.
My feeling is that you should exhaust all low-risk options first. Once you have your debt paid, then you can afford to play the markets, with money you can afford to lose.
tastyreasearch: in the UK and most of Europe, there is no tax relief on mortgage interest, so it really is worth paying down the debt. People in 1980's Britain didn't think that tax relief on mortgages would ever get abolished, but it did when interest rates got cut and the govt wanted to encourage repayment. Don't bet on tax relief being a permanent feature where you are.
jim: an offset mortgage is indeed the best way of achieving this, I have one with Intelligent Finance. But in addition to the savings in my savings jar, I do also make some actual overpayments to the mortgage too. I always feel that there is a chance the savings will get spent, but the overpayments are permanent contributions to reducing the mortgage.
For someone writing a money blog you don't seem to understand something as simple as an interest rate. Using your 10K example w/ a 5.5% mortgage and a 4% savings account the actual outcome is quite different. The 4% is a compound rate while the 5.5% is simple interest. Thus after ~18yrs you are better off using the 4% savings account. After 30 years w/ the pay 10K now example, you have saved $16K in interest, over paid 4K in taxes (at 25% rate) and are no closer to paying off your house. But, if you were to put the 10K in the savings account you would have $32K in the account, paid 5.6K in tax on the interest and saved 4K on taxes from the interest from the mortgage. (This scenario gets even sweeter if you buy almost risk-less Gov't Bonds, and better still w/ a properly diversified low risk bond/equity portfolio) Now the kicker, if you fall on hard times in the next 30yrs do you think the bank will let you take back any of that 10K??? No they will take your house, while if you had put it in the bank you could have made it through the hard time.
You should probably do a bit more research before you write your next blog...
True, the stock markets may not have yet come back up to their peaks of 2000 - but if you were saving regularly (monthly) you would have been dollar cost averaging so you would likely be ahead, overall. The only case where you would be down would be if you put ALL your money into the stock market at the time when it was at its peak. If you are talking a long (20 year?) time period I believe historically you would make out much better in the stock market than in your savings account.
Don't get me wrong, I am a big fan of paying off the mortgage, if only for the sense of freedom. But I don't think you should completely forego the potential gains from the stock market until you have paid off your house. You could (almost certainly would) be losing out on a fair amount of money by doing that.
Sorry Drewb - but the interest rate you are charged on your mortgage is a compound interest one, NOT simple.
No bank uses simple interest on ANY financial instrument these days. I think simple interest went out in the 19th century.
If you sincerely believe that mortgage interest is based on SIMPLE interest, - well words fail me - you've been had, mate! That's where you've been going wrong all this time!
good post....I've considered doing this for some time now and just haven't yet....need to soon
I'm trying, though, to cut costs every way I can (day to day costs, not bills) to set aside money for investing. I should do the mortgage thing too
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