For the love of mortgages

“Word nerds will notice an eerie root word in ‘mortgage’ — ‘mort,’ or ‘death ... The term comes from Old French, and Latin before that, to literally mean ‘death pledge.'” ^ref and yet, despite this roughly 70% of Australians are living with a mortgage.^ref

In the personal finance sphere destroying debt is a common goal. Bloggers celebrate living debt free, and lament every dollar lost to paying back loans. Every dollar in interest repayments is a dollar out of your pocket.

There's more to it than that though, which is why I'm not actively paying down my mortgage.

The house buying story

In 2014 my father passed away. My brother had moved out of the family home a couple of years earlier, leaving just me and my mother in the family home. A couple of months later in June I scored my first proper adult job, 9 till 5 office work. After a few weeks I learned three things about myself - No way in hell was I working in an office till my 60's, winter makes me cranky and while I love my mother I cannot live with her. At least, not without any other people as a buffer.

While I was reading Early Retirement blogs, I hadn't yet stumbled across the concepts of House Hacking and Rent-vesting. I knew I had the money to buy a house rather than rent so I could bring my pets along, and I knew not to buy outside my means.

Fast-forward three years and I own a comfy, dated 2 bedroom home that desperately needs a renovation eventually. I bought this property entirely in my own name, for $60k less than the banks said I could borrow, and my partner pays 'rent' (which all goes straight to the mortgage), While the decor is horrendously outdated it's nothing that desperately needs fixing. We could DIY some renovations and make the value of the property soar by taking it out of the 80s and into the current decade.

The cost of a house

As it stands, we should be poster children for paying down our mortgage quickly. I bought for less than I could afford without accounting for Mr. FIREs contributions, but here's the tricky part I don't want to waste money paying my mortgage early. (tweet this).

I currently invest $500 - $600 a month while I'm trying to hit my $20,000 cash savings goal. If I threw that money at my mortgages instead I could save $107,000 and knock almost 10 years off the life of the loan. As I've posted before, shortening the life of your loan is a really good thing.

There is something even better though. Something worth continuing my death pledge with the big scary bank. Instead of looking at your debts in horror, look at your net worth. Your net worth is simply the value of your assets (cash, stocks, house, etc.) minus your debts (mortgage, credit cards, those kind of things).

You can grow your net worth in two ways - by having more assets, or less debts.

The cool thing about assets though - once you've set them up they grow themselves! If you have $1,000 invested, next year it's going to be $1,070 (assuming a 7% return). Through compounding it grows even faster each year. Paying down your mortgages is great because you pay less in interest every year, but it doesn't compound in the same way that your investments do (although if you aren't paying your loans compounding will very quickly run against you!)

Maths and graphs

Let's say, hypothetically, that I owe $300,000 on a 4% loan (I actually owe a bit more than this across two properties, but lets keep things simple, the rate is right). Over a 30 year loan it costs $515,610 once you factor in the interest, and assuming that you invest and save nothing else and your property value doesn't change, you end up with a net worth of zero.

How utterly thrilling. After 30 years you are worthless, break out the champagne! Well, you have the equity in your house, but you can't use that to buy champagne, or put food on the table so I've left it out of this argument. In every case your equity would be the same, so to simplify maths lets just ignore it.

Trying another tact, let's throw a bit more money at this mortgage. A 30 year, $300,000 loan needs $1,432.25 a month in repayments, but for a nice round number let's make it $2,000. Your mortgage will be paid off in just under 18 years, and you decide now is a good time to invest. Rather than taking that $2,000 a month and living the high life, you just shift it into a nice safe index fund investment with 7% annual returns. Then your graph looks more like this orange line:

Amazing! After 30 years this time you're worth almost half a million! For an extra $570 a month from day one, you've managed to squirrel away a very tidy sum, in fact your investment portfolio is worth 50% more than you bought your house for!

In scenario one you spent $515,610 over 30 years to be worthless. In scenario two you've output $720,000 on paying your mortgage and investing and now you are worth $488,500. That will definitely buy you a bottle of champagne, and a waterfall to drink it from.

But you can still do better without spending a cent more. Your mortgage is costing you 4% per annum and shares are returning 7%. Each year you aren't investing you are missing out on that 3% difference. So instead, you choose to invest from day one. You make the minimum repayments on your mortgage ($1,432.25) and invest the rest ($567.75). Then your graph looks like this grey line:

See that line surging towards the heavens? That's you with no debt and an investment portfolio worth almost $700,000. In fact your investments are so huge that you can safely drawn down $2,300 every month. You are earning more from your investments than you've been putting towards them. Break out the champagne! After 30 years you own your home completely, no more mortgage, no rent and your investments are huge. Many people have retired on less, pat yourself on the back! If you do your maths properly and don't buy into the retirement income myth, you might just be free from the rat race.

Surely you can't be serious?

So why is this possible? Interest rates. Purely and simply, interest rates on mortgages at the moment are crazy low. I'm paying a mere 4% on my mortgages, whereas the share market has been returning an average 7% a year since we started tracking it. While a 3% difference might not sound like much, after 30 years it makes a massive difference.

Many people hate the idea of paying a mortgage and would never ever go back into debt. Others carry a mortgage while holding massive investments because they know that the returns on their investments will well outstrip the costs of the mortgage.

Me? I love my mortgage. I've been given 30 years to pay back this debt, and my lender isn't hovering over my shoulder demanding the money now, now, now! They know that if I pay it back early they lose out on making money from me. Well I lose out too, on all those years of compound interest.

I could be paying back the banks, or I could be setting aside money for my future self. Which would you prefer?

Spend you dollars, on more dollars!

Let's do some maths, baby! I'm going to talk about money, using your money to 'buy' more money, and investing. Plus I get to play with charts and graphs.

We're going to talk about interest, starting with the normal boring kind, then the compounding kind. Most people encounter interest in two ways - banks will pay you for leaving your money in an account. They will also charge you interest on loans.


For example, my bank pays me 3.05% per year. This is calculated daily and paid monthly. So every day I leave $1,000 in the account, they owe me 8cents ($1,000 x 3.05% = $30.50 a year. Divided by 365 = 8cents a day). Once a month they add up what they owe me and deposit into my account (roughly $2.55).

Inversely, my home loan runs at 4.14% p/a. So for every $1,000 I have borrowed, I pay the bank 11cents a day, or $3.46 per month. This is how banks make money, that $1,000 you have sitting in a savings account isn't in a vault somewhere guarded by dragons and goblins. The bank has given it to someone else - they pay you 8cents a day, charge the other guy 11cents and gleefully collect that 3cents for themselves. They aren't doing it in tiny $1,000 amounts, they're working in billions and trillions.

So obviously you win by taking that $1,000 that you have in savings and paying down what you owe on the loan. But when it's only $0.91 a month difference it's easy to see why you wouldn't. It doesn't cost you that much. But on a 30-year, $300,000 loan you end up paying almost $225,000 in interest.

If you're able to find a little extra money and push it into your mortgage, then you can bring those numbers down. (Related post: 3 ways to shorten your mortgage right now)

Okay, that's the unpleasant part about mortgages and costing you money. Let's look at the fun part of Compound Interest working for you.

Compound interest is more fun than regular interest. In the above scenario you only make $2.55 a month from your $1,000 savings. Which isn't even enough for a coffee.When you look at it over time, you probably imagine this graph.

Let's face it that graph isn't very inspiring. If you leave your money alone in a 'high interest' account for 10 years, you get less than $300. Woop de doo. Except that isn't 100% correct.

If you were to withdraw the $2.55 you were paid every month, this is exactly what would happen. But if you leave the $2.55 in the account, it also earns interest, a whole 0.6 cents in a month. Then next month you earn $2.55 point oh six cents. It's only a little tiny bit more, but each month it's a little tiny bit more than the last month. When you include compound interest you get a graph that looks like this.

So you come out $40 further ahead than you thought you would be. Doesn't sound like much, but with compound interest you have 3% more in ten years. Again, not a huge number, but it's free money. Then if you look at it over a longer period you also get this...

There are a few things about this chart that give me a nerdy little thrill. One is that in 30 years, you can get $1,343 of free money with compound interest, more than double what you put aside. Compounding gets you 26% more than if you withdrew your money every month. And that red line isn't straight, it's curving. Every month you don't touch that money, the amount of interest you are paid goes up. In the first month you were making $2.55. By the 30 year mark you are making $5.60 a month. And each month this amount is increasing a noticeable amount, $5.62 at 30 years and one month, then $5.63, then $5.64.

Admittedly these are tiny numbers. You can make it more exciting by moving the decimal point to the right, and working with $10,000 and $23.70 per month, but I thought having $1,000 in savings was a more realistic starting point.

I think most people miss out on compound interest, because we save small amounts of money for a short time. In the grand scheme of things, even saving for a house is a small amount in a short time, say $60k in 4 years. Starting from zero you need to save $1,250 per month. If you consider compound interest you need to save $1,174 per month, and you'll get $3,653 of free money from interest.

You're still doing the heavy lifting yourself and for many people buying a house will be their biggest purchase. For other savings goals like travel or a new car compound interest doesn't play in because the saving time is much shorter.

However, if you are saving for retirement or financial independence then compound interest becomes your best friend. Putting aside $100 a week for one year equals $5,200 + $73 interest. Over 25 years $100 a week becomes $130,000 + $64,626 interest. Again, the graph is a curve. And all this is assuming a measly 3.05% return in a high interest bank account like ING Direct (currently offering $100 sign up bonus with the code EBB062).

To really kick off your investments, have a look at RateSetter (returns over 8% with Peer-to-Peer lending) or Acorns (my personal returns are nearing 10%, long term I expect more like 7%)

If you made it this far, go play with the MoneySmart calculators, particularly the Savings Calculator and Compound Interest Calculator. Using these calculators I can see that at the 16 year mark and 8% investment like RateSetter will have earned more through interest that your have contributed. That is the power of compound interest.

(Related post: Where's my million? - includes a fancy calculator)

Boring disclaimer: If you sign up for ING I also get $100 for introducing you. They are a fantastic bank and I have never been charged a single fee. They also cover the cost of ATM withdrawals, and give you a little money back if you take out more than $200 cash during an EFTPOS transaction. I highly recommend them, not just because they are offering me a little cash as well.