Is it really practical to pay off loans early?

On the surface, it’s a no-brainer to pay off your home loan early. After all, a home loan is the biggest debt that most people will ever have, so it makes sense to want to eliminate it as early as possible. But how much financial sense does it make to do so?

Should you pay off your mortgage early? For many Australians, home loan is the biggest debt that they will ever have. This makes paying your mortgage off as early as possible a no-brainer. However, the answer to this question is actually not as simple as it seems. Financial-wise, there are several things you need to consider if you really want to pay your loans early.

Saving money in interest

One of the biggest considerations to take into account when deciding whether or not to pay off your home loan early is how much you will pay in interest over the amortization period. In order to have an estimate, you need to understand that your repayments cover two parts: the principal and the interest.

The principal is the amount of money that you actually want to borrow. This means that if you buy a home with a value of $550,000 and you have a 10% deposit of $55,000, you would need a mortgage of $495,000 from your lender.

But if you get a home loan with a 25-year amortization period, that does not mean that you will only have to pay off $495,000 over the life of the loan. That would be too easy. It would also not be of any benefit to the lender. As with most loans, you will have to pay interest, which is essentially the cost for the privilege of borrowing money.

Let’s assume that you were able to get approved for the loan at a 3.25% interest rate. How much are you going to pay monthly? Using Your Mortgage’s Home Loan Calculator, you will derive at a monthly payment of $2,412.22. Check out the results below:

Over the life of the loan, you will have paid an interest of $228,664. In total, you will be paying around $723,000 over the amortization period. Please take note that this computation assumes that the interest rate stays the same throughout the loan period.  

When it comes to paying off your home loan, most home buyers put so much effort into saving up that initial deposit that it has become hard to focus and take a look at the end game and the long-term financial strategy. But it’s important that you keep all of your options on the table so that when you’re ready to focus on your long-term strategy, your home loan allows you to take the appropriate action, whatever that may be.

There are a couple of ways to look at it, the first being the more common reaction: in the scenario above, you’re paying more than $200,000 extra on top of the home loan itself, which works out to an extra $8,000 each year, and no one wants to pay more money than necessary. There are ways to lower this number, such as making extra monthly repayments or lump sum payments, which will allow you to pay more money than required.

When you do this, you are actually reducing the amount of your principal. This, in turn, shortens the length of time required to pay off the loan. The less time it takes to pay off the home loan and the lower the principal amount of the loan, the less you will pay in interest overall.

If you have available cash, the most effective use of the funds is to pay extra on your mortgage, as it not only saves you paying interest at a higher rate than the interest you would earn on your cash, but it also means you are not paying tax on any interest earned.

The other benefit of paying your loan is you are not exposed as much to large rate increases. Depending on your mortgage term, these increases could raise or lower the extra that you will pay on top of the initial borrowed amount, but you would not be able to plan or account for that.

Investing instead

In the second scenario, the thinking tends to be that rather than putting every spare penny you have into paying off your home loan, you invest it instead. There are pros and cons to each side of the coin and sometimes home buyers do not consider all of the alternatives.

If you do end up paying your loan down, you will not have those funds for other investment purposes.

Low interest rates, while good for your home loan, are not great when it comes to saving your money. Vehicles like high interest savings accounts are not necessarily an effective way to hold onto cash. In fact, depending on the interest rate of the account itself, they may actually be losing money when you take inflation into account. Investing your savings could give you better returns on that money.

You could take any extra disposable income and put it toward your home loan in order to shorten the time it takes to pay it off or you could take that money and invest it wisely, which over the life of your home loan could get you more you would have saved in interest.

If you decide that you are focused on investment, then you have to look at your home loan options a little differently. You can, for instance, consider access to equity.

Putting a price on it

As with many things home loan related, it comes down to a personal choice: would you rather be debt-free sooner, or would you rather maximise the cash in your pocket at the end of the day? What risks are you prepared to take in order to meet your goals, or what are you prepared to sacrifice?

You might be the kind of homeowner who will always be thinking about the money you “lost” by not investing it somewhere that may have gotten bigger returns.

Or you may be the kind of homeowner who, regardless of what the returns that you might have missed out on, value the freedom that comes with truly owning a home, and not having a large debt looming over you.

Sure, you’ll still have a number of housing-related expenses to pay in order to maintain your home, but with hundreds, sometimes thousands of dollars freed up each month, you’ll be able to take that money and invest as aggressively as you would like, without worrying about the bank taking your home, ruining your credit, and you not having a place to live if the going gets tough.

This is an updated version of a guide first published in 2017.

Published at Sun, 04 Oct 2020 15:13:10 +0000

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