Most people’s home loans take twenty-five to thirty years to pay off. They pay massive amounts of interest. What if I told you that you could pay it off much sooner, and save on almost all the interest?
Many people aren’t aware that they can pay off their home loans much quicker than the term on the bond. There is no drawback to paying it off sooner in terms of your bond, and it’ll save you a lot of money.
I’ll use South African Rands to illustrate my point, but all calculations carry over to dollars. ($1 is about R14).
In theory, someone who buys a R400,000 car and pays it off over 5 years could just as well buy a house for the same amount and pay it off in the same time.
A R400,000 home would be a much better choice than a car. A car is a depreciating asset, and a home is an appreciating asset. The home is the clear winner when both options cost the same.
Turning a 20-year contract into a 5-year contract means you’ll have to pay double your monthly installment. (But don’t take a 5-year contract — just overpay on your installments in a 20-year contract).
It may sound like a lot to pay every month, but taking into account that it saves you 75% of the term and about 90% of the interest… Well, it’s easy to see why it becomes a worthwhile option.
The perfect scenario
Let’s say you were looking to buy a home for R1,000,000. Let’s assume an interest rate of 10.25%, and the standard payment term of 240 months (20 years).
If you pay it off normally you’ll have paid a total of R2,372,504.13 over a period of 20 years. If you paid double your monthly installment you’ll have paid only R1,278,387.49 over five years.
That’s probably the biggest saving you’ll ever make! Forget 5% off at Wal-Mart, invest in paying off your home quicker.
The not-so-perfect scenario
So what if you can’t afford double the bond? What if a place at half the price is too small? What if you’ve already bought a house? Can you still use this to your benefit? Of course!
You don’t have to pay double your installment. In fact, unless you have a particular set of circumstances, you probably won’t be able to. But you can still pay an additional installment.
Unless you get a guaranteed rate on your investment portfolio of at least the interest rate of your bond, you’re better off paying an additional installment on your bond than investing it. (But, as always, diversification is important so don’t stop your investment just yet).
I’ll illustrate three scenarios using the R1,000,000 bond example. Scenario one shows what would happen if you pay the normal installment of R10,000 (blue line).
Scenario 2 illustrates the situation if you pay an extra R2,000 per month(orange line), and scenario 3 illustrates an additional payment of R5,000 per month (green line).
The advantages of paying your home-loan early
- You save a ton of money by cutting on interest.
- You acquire an asset in a much shorter term.
- You eliminate the risk of defaulting if your financial circumstances take a turn for the worst.
- It provides you with a safety net in difficult economic times.
- After the term, your disposable income increases significantly.
The possible disadvantages to consider when paying your loan early
- If you have other debt it may be advisable to pay that first, as the interest rate on other debt such as a credit card is much higher.
- If you’re renting out the property the interest is tax deductible.
- If you don’t notify the bank 90 days in advance before closing the loan account you may incur cancellation fees.
My personal tips for (realistically) paying your home off in 5 years
It seems great on paper, but so does digging a 100-meter trench with a dinner-spoon. It’s when you actually try it that the task reveals its true difficulty. Here are a couple of tips that might help make it a bit easier:
1. Avoid debt, live on cash
Paying your home loan early doesn’t make sense if you’ve got other debt. A home-loan is generally a low-interest debt. So paying an extra R10,000 on your home that has an interest rate of 10.25% makes no sense when you’ve got R10,000 outstanding on your credit card at a 20.25% interest rate.
If you make improvements, pay for them in cash. If you buy clothes or luxury items, save up for it rather than paying off your credit card later.
2. Know your goal
Keeping your goal in mind will make the additional payment much easier. Unlike your minimum payment, you’ll be able to stop the additional payment. Knowing this will tempt you. Missing some payments is a quick way to lose focus and stop making additional payments altogether.
What’s your goal? Do you want to acquire an asset early in life, and use it later as an additional source of income? Or do you want to finish paying your home early to increase your disposable income?
Whatever your motivation — always keep it within view.
3. Buy less house than you can afford
The bank will likely offer you more than double what you should be paying. Resist the temptation to buy an overly-large home that you’ll pay off for the rest of your life.
Construct a written budget and find what you can really afford. Buy something for that amount, and not a cent more.
4. Limit the debt on your car
Buying a shiny new car will break your budget more quickly than you realize. Buy something reasonably priced that you can drive over a long period of time. Take care of it as if it were the only car you’d ever buy.
A car is a depreciating asset. That means you’re paying a monthly installment on something that reduces in value over time. A home, in contrast, is an appreciating asset. It’s an installment for an asset that gains value over time.
The balance between the debt on your home and the debt on your car should be finely kept. In my personal opinion property debt is “good debt”, and car debt is “bad debt”.
5. Keep a tight, written budget
In an earlier post, The 4 Principles of Accumulating Wealth, I explained the value of keeping a written budget. Write down how much you can afford to spend on what each month.
Sometimes you’ll need to stretch the dollars and other times you’ll have a surplus. A tight budget will help you keep control of your expenses.
You might read this post and think: “I want to pay off my home in 5 years — that’s a great idea!”. Or, you might read it and think: “I’d rather pay half the amount, keep it up for 20 years, and live with less financial stress.”
