By Sagarika Mishra*
By paying just $1 a day extra on your mortgage, you can hack the banking system and cut the time to repay your home loan from 20 years to just five years.
Sounds too good to be true? Of course it is. But that hasn’t stopped someone “good at finance” from claiming this in a TikTok video that’s garnered millions of views and spurred dozens of other “finfluencers” to amplify its claims.
According to the video: “The reason banks want you to pay interest monthly is because they rely on a thing called compound interest.” But if you pay the bank $1 every day you “will pay a big fat zero in interest”.
The video goes on to say “mortgage” is a Latin word, and the reason “they” stopped teaching Latin in schools is because “they” don’t want people understanding how the banking system works.
If this sounds like a conspiracy theory, it’s because it is. Like all conspiracy theories, this one is a falsehood built on a few grains of truth, taking advantage of people’s ignorance about complicated matters.
So let’s separate the facts from the fiction.
What is compound interest?
Compound interest, in a nutshell, is interest on interest.
Say you put $1,000 in a savings account that pays 10% interest. After the first year, you would have $1,100 ($1,000 + $100 in interest). At the end of the second year you will have $1,210 ($1,100 + $110 in interest). At the end of the third year you will have $1,331 (1,210 + $121 in interest). The interest compounds.
What if you’ve borrowed $1,000 at a 10% annual interest rate? Assuming you make no repayments, after one year you will owe $1,100 ($1,000 + $100 in interest), after two years $1,210 ($1,100 + $110 in interest), and after three years $1,331 ($1,210 + $121 in interest). Again, the interest compounds.
How to avoid compound interest
To minimise the amount of compound interest you pay, there is one effective strategy: pay off the loan as quickly as you can.
Let’s consider an example similar to the scenario mentioned in the TikTok video – a mortgage with a loan term of 20 years. To make the maths easy, let’s say the loan is for $500,000 with a 5% interest rate. To pay it off in the allotted time will require monthly repayments of about $3,300 – or $39,600 a year.
Over 20 years you will pay about $792,000 – with about $291,950 being interest. The following graph shows this.
Now let’s consider what would happen if, instead of paying $3,300 a month, you paid $1,650 a fortnight. At first glance that might seem like the same thing, but it isn’t.
In a year there are 12 months, but 26 fortnights (because only February is exactly four weeks’ long). Paying half your monthly repayment every fortnight will mean you pay $42,900 a year, instead of $39,600.
If you can afford to do that, it will take just 17 years and six months to repay the loan, and you will pay about $41,750 less interest. The following graph illustrates this.
So what about paying daily?
Paying more frequently, such as weekly or daily, won’t make any difference unless you’re paying more.
There’s no magic trick to stopping compound interest. The following graph shows what an extra $1 a day would achieve with our hypothetical $500,000 loan.
Rather than taking 20 years to repay the loan, it will take 19 years and nine months. You would save about $5,470 in interest (paying about $286,480 rather than $291,950).
To repay the loan in five years, as claimed, would require paying an extra $201 a day – or about $113,220 a year instead of $39,600.
There are no secret hacks
So there’s no magic hack to avoid compound interest.
There are strategies to improve your loan conditions, such as refinancing when interest rates are declining, or using an offset account facility where these are offered.
The only real way to minimise compound interest on your mortgage is to pay off what you owe as quickly as you can.
But before you do, check with your bank if there are fees involved if you make additional payments towards your home loan.
For instance, if you have a partially or fully fixed mortgage, there may be a limit on how much extra you’re allowed to pay off each year without penalty.
These penalties are intended to compensate the bank for the loss of interest income it would have received if the borrower had continued to make regular payments over the full loan term.
*Sagarika Mishra, Associate professor, Deakin University. This article is republished from The Conversation under a Creative Commons license. Read the original article.
17 Comments
Paying the mortgage off early normally requires a mix of strategies ideally with some luck. Rather than just one. Stuff like:
- buying property when cheap (bottom of market) rather than the top. Maximising savjngs for deposit during the boom time.
- smartly sourcing the best mortgage rates and fixing chunks of the mortgage for diffetent timelines to minimise risk of interest rate changes
- selecting an account where the balance of your everyday account offsets against the amount you pay interest on.
- if young and possible things like renting out rooms to cover costs helps and pay off he principal faster.
- smart career moves to maximise income
- budgeting to minimise outgoings
Basically being smart with money....
Top tip i got from this site:
Work out how much you can pay off each year and have that portion floating (even at a higher interest rate you'll save because you'll be paying that on less debt very quickly).
Also have a chunk fixed at one year (which will then go on floating once you've paid off the first floating bit)
Then the rest at 2 years which you then switch part of to 1 year at year 2.
Rinse and repeat till it's all gone :)
There are secret hacks, you pay it off a frequently as possible, i.e weekly and not monthly and just by paying an extra $50 a week does slash years of the mortgage. Unless you are getting that principle down as quickly as possible you are just getting smashed by the interests payments. Just throw numbers into a mortgage rate calculator to see the difference.
1. Understand the rule of ‘72’s’ to appreciate compounding.
2. Get a second job to kill principal.
3. Use moneychimp to work out how much interest you could avoid paying if you forgo the ‘new’ car or overseas holiday.
Most kiwis are consumers and financially illiterate. Mortgaged to the hilt but still spending up.
Is mortgage interest no longer calculated to the rule of 78? Used to be the first payment you made was 99% interest and 1% principal, 2nd payment 98% interest 2% principal or there abouts, and so on it went. The best and only was to reduce your total cost was to reduce the term from 20 or 30 years down to say 10 years on application and pay it off as fast as you could. Slowly banks did allow you to make principal only reduction payments. Everyone moans today about their mortgage but the terms seem to offer a lot more flexibility these days. Anyone who takes financial advice from Tik Tok should probably not have a mortgage in the first place.
Changing from monthly to fortnightly is a valid and applicable truth. Well done.
Taking any spare cash and using it to increase repayments is also the right approach.
Using Tik-Tok as a source of either a) truth or b) advice will only cause pain and suffering. Avoid.
Mortgage is derived from Latin. Mort from death. Gage from bond or security. So Mortgage is a death bond.
Of course you won't beat the bank, but all the clowns that reduced their mortgage repayments and spent up when interest rates dropped will now be regretting that their mortgage term is still the same as when they took it out. And worse still for those that refinanced and increased their mortgage when rates were low.
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