We have mentioned that many people have large mortgages that cannot be paid off quickly since the mortgage amount is typically 1, 2, 3, 4 or even 5 times bigger than the homeowner’s annual income. The mortgages are therefore designed to be paid off over many years – 15, 20, 25, 30 or even 40 years from first drawdown.

In the previous posts of this mini-series we talked about clearing your debts before you begin to invest. You can review those posts here:

Before you begin to invest – step 1
Before you begin to invest – step 2
Before you begin to invest – step 3

In the case of a large mortgage, since we cannot just payoff the mortgage, we have to manage our mortgage costs and this means we have to make sure that we pay as little interest as possible. The less interest we pay, the more money we have to invest.

The actual amount that is paid out in interest by mortgage holders to banks / lenders can be very large and in most cases is actually more than the mortgage amount in absolute terms.

You probably don’t believe that but let me show you by way of an example:

If you had an interest-only mortgage of say $100,000 and the interest rate was fixed at 5%, then the annual amount of interest to be paid is $5,000 (5% of 100,000). After 20 years, you would end up paying $100,000 in interest (20 times $5000), which is the same as the amount borrowed in the first place!

After 30 years, the amount of interest paid will be $150,000 (30 times $5000).

You can immediately see that the interest cost is massive.
That is money that is gone from your account forever.

Any person lucky enough to buy that house outright for cash would not have to pay any of that interest. They could invest all of that interest not paid. Financial freedom would be most likely guaranteed for such people.

The majority of people are not so fortunate to have enough cash to purchase a house outright for cash – a mortgage is the only possibility and so paying interest is inevitable.

Note that in the example above we considered an interest-only mortgage. An alternative type of mortgage is a repayment mortgage. This has an element of loan repayment each month, so that the amount of interest incurred reduces each month. However, the argument still holds true – a large amount of interest will be paid over the life of the mortgage.

So what should mortgage holders do ?
They need to reduce their interest costs – but how?

Two things can be done to reduce interest costs and both should be done:

First of all, make sure that you have the lowest possible interest rate for your mortgage – over the life of the mortgage. Thats fairly obvious. A 1% reducation in your mortgage rate will save you $1000 every year for every $100,000 borrowed. That is money that adds up – it could be money in your investment account rather than being in the lenders account.

The second thing you can do to reduce your interest cost is to reduce your mortgage balance. If you are able to payoff 1% of your loan then you will incur 1% less interest – simple as that. If you can payoff 10% of the loan balance you will pay 10% less interest in the future.

By taking advantage of these 2 strategies, you will pay less interest every single year. That will allow you to plough some of that interest saved into paying off more of the loan balance. The quicker you can do this, the quicker your mortgage will be paid off. The quicker you can payoff your mortgage, the more money you can put into your investment portfolio.

So there you have it. The first 4 articles in this series have shown you the benefits of clearing your debts as quickly as possible and also explained why you have to manage your loans (to save interest costs).

Footnote:

There are generally two main types of mortgage available. The first is known as an interest only mortgage and the other type is a repayment mortgage. With an interest only mortgage you only pay interest every month and then you have to make one big repayment of the outstanding debt at the end of the term (which as we know can be 20, 30, 40 years away).

The other mortgage type (repayment) is different in that every month you also make small capital repayments alongside the interest payments. The small capital repayments are calculated such that you eventually do payoff all of the loan by the end of the loan term.

So you can see that with the interest only mortgage you have to have great discipline to save up the entire loan balance in order to pay it back at the end of the term. The lender will not force you to make capital repayments early nor will they check upon on you to make sure you are making arrangements to build up a lump sum to payback the loan at the end of the term. They do however want their money back at the end of the loan agreement. If you cannot pay it back, they will repossess your house and you’ll be left homeless.

The repayment mortgage does not require as much self discipline since you will be contractually obliged to make those small capital repayments each month. Those small monthly repayments will eventually clear off the entire loan at the end of the term.