Financial advisors and banks have been telling folks for years that they should hand over extra money every month toward their mortgage in order to reduce the time period for paying off the loan and to cut down on the interest forked out.
Boiled down, a $200,000 at a rate of 5% would cost about $1074 per month over 30 years. Over 30 years, you would actually hand over $1074 x 360 (months), which is $386,640. That's $186,640 in interest!
You could cut 10 years off your mortgage payment period if you could simply fork over your typical mortgage charge plus an additional $246 each month. On top of that, you would cut the total to $316,664 and save an incredible $69,756!
OK, so maybe now the little voice in your head is saying something like, "I don't want to pay more every month I want to pay less every month like the title of the article says. Now I am to show you why forking over much more money toward your mortgage is not the best move that you can make. The flaw in this technique is that it ignores the time value of money.
However, before we get into the time value of money, let me first explain why the banks and financial advisors preach what they do. With the banks, it's pretty simple your paying your mortgage faster means less risk to them and it gives the opportunity to lend the money to someone else. In addition, when banks decide what people to target for foreclosures, they always pick the people that have PAID MORE toward their mortgage because they expose themselves to less risk. This is contrary to the beliefs of most people that tend to think that because they coughed up a lot more, the bank won't target them. 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 Hilton Hotel empire is probably the best example of this. During the Great Depression, when homes were being foreclosed on left and right, the Hiltons did not have one property foreclosed on even though they fell behind in the 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.
I really have no idea why, when it comes to financial advisors, that they tell their clients to go this route. They know that the banks first target those that have forked out more. Finally, having their clients pay off their mortgage actually costs their clients and themselves (because they get paid by making their clients money) a ton of lost profit because of the time value of money.
Just about every single person knows that money was worth more when they were younger because of inflation. Using the mortgage example above, in thirty years time, the last amount of $1074 will only be worth about $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 cannot simply subtract the mortgage interest amount for a 20 year mortgage from the interest on a 30 year mortgage. Instead, you must calculate the "Present Value" of every mortgage option to determine which is best.
The Present Value of a 30 year mortgage fixed at a 5% interest rate and with payments of $1074 is $200,066.
The Present Value of a 20 year mortgage with repayments of $1320 at a 5% interest rate is $200,066. The Present Value of a 20 year mortgage fixed at a 5% interest rate and with payments of $1320 is $200,066.
The two repayment schemes are exactly equal.
The $69,756 "savings" in the interest rate is really just the effect of adding the extra $246 a month into the repayments - in fact, that $246 a month adds up to $59,040 over 20 years.
Now, what would happen, for example, if you took that $246 a month and invested it elsewhere in something safe and conservative like a mutual fund?
If you could get an average return of 10%, after 20 years you would have $186,804 (Note: the S&P 500 has averaged 10.83% over the last 50 years and would make an S&P 500 Index Fund a safe yet powerful choice.) That would be worth about $102,597 in today's money with inflation hovering around 3%.
To get even more answers, let's ask the question we asked before. Why would the banks recommend that you pay off your mortgage quickly? Surely the longer the income stream lasts, the better, right?
Banks love to prove that they will "save you money" and make it seem like they are doing it only for your benefit. 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 cough up, 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 forking out 5% interest means that you can't use that money to earn 10% or 12% or 15% somewhere else.
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. The fact of the matter is that most do not own their homes free and clear because they understand that their money can make them much more money in other investments rather than sitting in the walls of their homes. Bill Gates took out a mortgage for his new home. The Home Depot doesn't own any of the land or buildings that they use. Why should you pay off your house?
Of course the title of this article talks about actually reducing your monthly expense 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 decrease your monthly expense while at the same time build your wealth then please contact me, Ed Brancheau, at 310-770-2369.
Ed Brancheau is a mortgage financing Whiz who can teach you to decrease your payments, pay off your mortgage much faster and build wealth. Call him at 310-770-2369 for more info.
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