Don't Rush To Pay Your Mortgage

By David McEwen

Monday 16th July 2001

Most people think paying off their mortgage as quickly as possible is the best use of their money. After all, the longer it takes, the more you have to pay back in interest costs. If you invest your money elsewhere, then you are effectively borrowing money at the current mortgage rate - and there are no low-risk ways of making a superior return.

That argument makes sense at first glance, but it doesn't take into account the time value of money.

Even in a low-inflation environment such as we have enjoyed for several years, our money is still losing value at the rate of two or three per cent a year.

That means the money you pay back to the bank on your mortgage in the future is going to buy less than it will now. Although the face value of the money you repay to the bank for a lengthy mortgage is much higher than for a shorter one, the present value of those funds is not.

Here's an example. Assume Mr & Mrs Short-term borrow $100,000 from the bank for ten years at 8% a year. By the time they've made the last payment in 2011, they have paid back a total of $145,560 at $1,213 per month.

Their next-door neighbours the Long-terms borrow the same amount, $100,000, but pay it back over 20 years. By the time they have made their last payment, they have paid back $200,746 at a little over $836 per month.

At first glance, the 10-year term seems more beneficial than the 20-year one. Most people would rather have the $55,000 difference sitting in their accounts rather than the bank's.

However, the picture changes if we discount each payment by a 3% annual rate of inflation to see what it would buy today.

In ten years time, the value of the Short-term's last payment of $1,213 will allow the bank to buy $900 worth of goods or services, a decline of 26%. The Long-term's last payment $836 will give the bank only $460 worth, a drop in value of 45%.

Over the life of their mortgages, the Short-terms are paying back $125,890 worth of capital and interest in today's dollars while the Long-terms are paying back $150,257. In other words, it is costing the Long-terms just over $24,000 in dollars at today's value for an extra ten years of borrowing.
Many people would say that is a price worth paying to enjoy considerably lower monthly payments.

That extra cost becomes even less if the difference in monthly mortgage payments is invested. Let's say the Long-terms take the $377 monthly difference between repaying 10-year and 20-year mortgages and invest that in government stock. After taking away tax and discounting their returns to today's dollars, they will have made $10,136.

That makes the net cost to the Long-terms of doubling the term of their mortgage to around $14,000 or $27 a week. If inflation were to rise above 3% (and in New Zealand the historical average has been much higher) then their real costs would be even lower.

Considering these figures, it is not surprising the banks make such a big fuss about helping people pay off their mortgage more quickly. Bankers realise that money received today is worth more than tomorrow - most borrowers don't.

David McEwen is an investment adviser and author of weekly share market newsletter McEwen's Investment Report. He is commissioned by the New Zealand Stock Exchange to write an independent personal investment column. He can be reached by email at davidm@mcewen.co.nz.

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