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?
Saving money in interest
One of the biggest considerations to take into account when deciding whether or not to pay off your home loan is how much you’ll pay in interest over the amortization period, which is the life of your home loan. With almost every loan, there are two parts: the principal and the interest. The principal is the amount of money that you actually want to borrow. So if you buy a home that’s $450,000 and you have a 10 per cent deposit of $35,000, you’d need a home loan of $415,000 from your lender. But if you get a home loan with a 25-year amortization period, that doesn’t mean that you’ll pay off $415,000 over the course of 25 years. That would be too easy – and not be of any benefit to the lender! So, as with most loans, you pay interest, which is essentially paying for the privilege of borrowing money. This is where the importance of interest rates come into play.
Using a home loan calculator with a 3.7 per cent interest rate, your monthly payments will be $2,122.37. But if you take a look in the second column, you’ll see that the amount of money that you’ll pay in interest over the life of the loan is $221,711. So your $415,000 loan is really costing you $636,711.
When it comes to paying off your home loan, most home buyers put so much effort into saving up that initial deposit and securing the home that they want that it’s hard to change focus and take a look at the end game and the long-term financial strategy for a home purchase. 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 accelerated payments or lump sum payments, which allow you to pay more money than required, which goes toward the principal and shortens the length of time required to pay off the loan. And the less time it takes to pay off the home loan and the lower the principal amount of the loan, the less you’ll pay in interest overall.
“If you have available cash then it is by far the most effective use of the funds, 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,” says Declan Murphy, managing director at QuickSelect. “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’ll pay on top of the initial borrowed amount, but you won’t be able to plan or account for that.
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 don’t consider all of the alternatives.
“The trade-off is, if you do pay your loan down you don't have those funds for other investment purposes,” Murphy says. “The core goal will influence the decision but often it takes additional enquiry; some clients will be obsessed with paying off their loan oblivious to other options and some are so focused on investment they don't consider the risks.”
Low interest rates, while good for your home loan, aren’t great when it comes to saving your money. Vehicles like high interest savings accounts aren’t necessarily an effective way to hold onto cash, and depending on the interest rate of the account itself, may actually be losing money when you take inflation into account. Investing it could give you better returns on that money. So 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’ve saved in interest.
If you decide that you are focused on investment, then your have to look at your home loan options a little differently.
“If [you’re] focused on investment then flexibility is key, allowing the client to access equity while also ensuring that the available facility is maximized. Lender selection will also be heavily influenced by servicing criteria and lending parameters,” Murphy says.
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 and 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? Murphy warns that things
“[Buyers] forget to enjoy life, and our situations change,” he says. “When you buy a house you can have available funds, then maybe you have kids and it becomes tighter but people still try to pay the mortgage off quickly - sometimes it’s better to step back for a while and reduce your payments and enjoy family. Once they're gone the mortgage will generally get paid much quicker as income has increased but expenses dropped significantly.”
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.