In this article we will explain a strategy for paying off your mortgage in just five to seven years. You can apply similar techniques to other kinds of debt such as personal and car loans.
Start by thinking about your total yearly income (after tax), and divide this by 12 to get your total monthly income. For this example let’s consider that your yearly income after tax is $60,000, then you will have a monthly income of $5,000.
Next, look at your monthly expenses:
- Mortgage repayments: for example on a $200,000 loan, with a 30 year fixed mortgage, you may have a monthly repayment of $1,200 at 6% interest
- Credit card repayments: for example if you have $12,000 owed on credit cards, your minimum repayments will be around $600 per month, with 16% interest
- Car loan repayments: may be around $600 per month
- Living expenses (food, utilities, entertainment): for this example let’s estimate $1,200 per month
So for this example total expenses per month are $3,600. Take this from your after-tax monthly income and you will have $1,400 left over. Most people will take this $1,400 and put it into a savings account for either long-term or short-term savings.
This means at the end of the month, you have earned $5000 and after considering repayments, living expenses and money put into savings, you will have spent $5000, so will have zero cash flow.
This is a very common way for people to manage their finances, however there is an alternative approach that you may want to consider if you want to pay off your mortgage in 5-7 years rather than 30.
First, lets look at some important information you need to understand about your debt and your finances.
- Understand the difference between interest paid on your credit card and interest on your home loan
Although on your credit card you are paying 16% interest, and on your home loan you may only be paying 6% interest, and so it seems that you are paying much higher interest on your credit card compared to your home loan.
However, there are two key differences between these types of debt: Firstly, your credit card is revolving or two-dimensional, which means as soon as you pay down your card you can access those funds again and use your card for purchases. Your home loan on the other hand is one-dimensional, meaning once you pay off a portion of it you no longer have access to those funds.
Secondly, your credit card calculates interest as simple interest: that is, a basic percentage on the money that you owe. Home loans are amortized, which means that you are paying interest calculated on the expected life of the loan.
- On a typical home loan schedule, you will only start to pay off a large portion of the principal 17 years into the loan
Lenders calculate home loan repayments based on the interest you are going to have to pay across the life of the loan. For most mortgages, the vast majority of your payments at first are going towards paying off interest, and only a small amount going towards the principal. In most projections, the point where you will start to make real headway on paying off the principal is 17 years into the life of the loan!
For our home loan example above, of the monthly repayment of $1200, at first you can expect that around $950 goes to repay interest, and $250 goes to pay off the principal.
Let’s look at what happens four years into your home loan.
4 years x 12 months = 48 months total, so 48 x $1,200 monthly repayments = $57,600 paid in 4 years
Using our month repayment breakdown, in the first 4 years you will have paid:
$950 x 48 = $45,600 paid towards interest
$250 x 48 = just $12,000 paid towards the principal of the loan
So, of your $200,000 loan, you have only reduced it by $12,000 in the first four years, even though you have paid $57,600 towards your mortgage in this time.
It is important to understand how this works particularly if you are considering refinancing your mortgage. Often you will have the opportunity to refinance your loan at a better interest rate, which can be a great idea and help you pay off your mortgage sooner. However, it is important to check whether refinancing your mortgage will mean “resetting the clock” on your amortization schedule, meaning a higher percentage of your repayments will go toward servicing interest again, like they did at the start of your loan.
Worst case scenario, if you keep refinancing your mortgage every four years, you could be stuck in a cycle of paying interest on your loan only rather than the principal, and never paying off your loan!
Another important thing to consider is whether putting your money into a saving account is the smartest thing to do. For a young age, we are told to put our money into savings. However, if you put the $1400 in our worked example above into a savings account, you may receive around 1% interest on this money. However you are still paying interest at a much higher rate on your credit card and your home loan.
Considering all of this, there is an alternative strategy to managing your finances. Under this alternative strategy, the approach is:
- Take your entire monthly income of $5000 and use this to pay off your credit card. So in the example, your credit card balance will reduce from $12,000 to $7000.
- Use your credit card to pay your living expenses and your mortgage, bringing your credit balance back up to $9000.
- By making these kinds of payments every month, in this example you will have completely paid off your credit card in 6 months.
- You can then take the $12,000 of available credit on your card and use this to make a payment on your mortgage. It is very important that this payment goes towards the principal of your loan, rather than interest.
- From here you will have $12,000 of credit card debt, but you can pay it off across the next 6 months using the same strategy (steps 1-4 above).
Consider that by this method you will pay off $12,000 of the principal of your mortgage in 6 months, whereas in the traditional method it would take you four years to pay $12,000 off the principal of your home loan. Moreover, you will save paying $45,600 in interest.
You may also be concerned about having emergency back-up funds. However, in this example you will be continually paying down your credit card, so you will always have the balance off your card available to cover emergencies which come up. It is important (for this reason and also to maintain a good credit rating) to never completely max out your credit cards.
Continue this strategy, paying off $12,000 from the principal of your home loan every 6 months, meaning that you will be able to pay off your $200,000 home loan in around 8 years. However, you should be able to reduce this time even more because if you regularly use this much credit and consistently pay it off on time, your bank is likely to offer you a higher credit limit, meaning you can pay off $15,000 or more every 6 months, and so will easily pay off your 30 year mortgage in 5-7 years!