Did you know the first few years of your home loan repayments are just paying off the interest? You are barely reducing the balance. However, refinancing can tip the scales in your favour.
The reason for this is that a home loan operates like compounding interest in reverse. To understand what this means and why it is important we need to look at what compounding interest actually is.
Let’s assume you invest $100,000 and earn interest at 5%. Your $100,000 grows by $5,000. But when interest is calculated again it is now based on the balance you invested ($100,000) plus the interest to date ($5,000). So 5% interest earnings are now applied to $105,000 which then grows by another 5% or $5,250. And so on it goes.
|Year||Start balance||Interest at 5%||End balance|
You are not only earning interest on the initial investment but you are also earning interest on interest. Your initial investment is compounding over time. To sum up – THE BALANCE GROWS AT AN INCREASING RATE.
Compounding interest is one of the golden rules of investment.
Investing and compound interest
When you start off investing you are earning very little (relative to a mature investment). As seen in the table above and graphically in the chart below, year 1 earns very little in interest relative to year 30. At the end of the 30th year, the investment is earning over 4 times more in interest than it did in year 1. The investor will earn over 20% of the initial amount invested in year 30 alone.
This is why you hear finance professionals always recommending that you start investing as soon as possible. The early years won’t show much of a return but eventually your balance will get to a point where compounding earns a large percentage each year of what you initially invested!
Another golden rule of investment is regular contributions. That is, if you actually ADDED MONEY on a regular basis to the investment the end results are even better. Using the above example, a regular investment of just $5,000 each year on top of the initial $100,000 sees a final balance of $764,000 rather than $432,000!
This has important implications for home loans (but in reverse) as we will see.
Mortgages – compounding interest in reverse
So what does this have to do with mortgages?
When you have a home loan the lender will work out a payment schedule based on the interest rate they offer you. That regular payment is made up of two parts
- the principal repayment (the balance you owe), and
- the interest repayment.
At the start of your home loan very little of your repayments are actually paying off the principal. The bulk of your repayments are actually going towards the interest payments (see table below).
|Year||Start balance||Interest due at 5%||Principal paid off||End balance|
This makes sense because unlike an investment which grows over time from a small beginning balance, a home loan starts with a BIG amount that you then pay interest on. The difference with a home loan is that this interest isn’t money you are earning – it is money you have to pay the lender for borrowing their money.
Below is a graphical representation of the table above. In this scenario the lender has determined you have to pay back $28,115 per year for 30 years at a rate of 5% per annum. That will pay them back the original $432,194 loan plus a lot of interest (which compensates them for the risk they take in lending to you).
As time passes the fixed $28,115 repayments are slowly reducing the ‘principal’ or ‘loan balance’. You can see that over time more and more of the repayments go towards principal rather than paying interest (orange bars increase while blue bars decrease). Eventually in year 30 there is no loan left to pay off (red line is at zero).
This is because the remaining loan balance that interest is calculated on is reducing with every passing year (red line in the chart above). Note in the chart above the amount going towards reducing the loan balance starts off at a small $6,505 in year 1 (orange bars) but increases in size until year 30 when $26,766 of the total repayment goes towards reducing the debt.
To sum up – THE BALANCE OF THE DEBT SHRINKS AT AN INCREASING RATE.
There is a very important lesson in all this that everyone should be aware of – in the first few years of your loan most of your repayment is just paying your interest bill.
Using our theoretical example, note that in the chart above there is nearly 3 TIMES MORE INTEREST paid in the first 5 years (blue bar) than you pay off the loan balance (orange bar)?
The implication is clear – if you can make ‘extra repayments’ in the early years of a loan it will be paid out quicker with a lower total interest bill.
Minimum repayments are going to just be covering the interest payments (their ‘risk fee’ for lending you their money) and a minimum balance repayment.
So what can or should you do?
In order to pay less interest there are two things you could focus on.
- Get a lower rate, and/or
- Make extra repayments to the loan (particularly in the early years).
As noted in a previous article (Refinance Your Home Loan: A Pay Rise to Live Life), refinancing with us with presents you with a lower repayment amount. As mentioned, this is due to the lower interest payment required each year (because interest rates are lower). Consequently, you can use this money as extra cash flow to live your life more if you wanted.
Using our example again, if you could find a lower rate (4% rather than 5%) you would save $3,121 each payment year.
HOWEVER, if you used the extra cash flow of $3,121 as extra repayments on your loan it further reduces the principal (outstanding balance). Continuing with our example you would continue to make the $28,115 repayments but the extra $3,121 goes straight off the balance and NOT towards interest. Anything above the minimum repayment reduces the loan balance (or principal) that interest is calculated on and therefore your total overall cost.
The end result is that you will pay the loan out earlier. That means you will save many monthly payments. If the loan is paid out 4 years early (as per the example) then 48 monthly payments are saved. Also note the interest payments are lower right the way through.
If you are interested in owning your home sooner through refinancing then you have a couple of options: