[The Conversation]

You can’t beat the bank by paying $1 a day extra on your mortgage. Here’s how compound interest really work​

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.

Effect of compound interest​

Paying off a $500,000 mortgage over 20 years (240 months) at 5% interest will require minimum monthly payment of about $3,300. It will cost almost $292,000 in interest.

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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.

Paying fortnightly instead of monthly​

Paying $1,650 a fortnight instead of $3,300 a month will reduce repayment time by 2.5 years and interest paid by about $41,750.

Get the data Created with Datawrapper​

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.

Effect of paying an extra $1 a day​

Paying an extra dollar a day on our hypothetical $500,000 mortgage will reduce repayment time by three months and save about $5,470 in interest.

​

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.


This article was first published on The Conversation, and was written by Sagarika Mishra, Associate professor, Deakin University

 

[MariaG]

This is a return of something that was a trend years ago.
It makes common sense that if you pay extra on a loan, it will make a difference over time.
In this modern age, however, there are so many different kinds of loans. People are so desperate to buy those dream homes they will commit whatever way they can to get the loan.
I have seen some people get interest only loans, meaning, the principle never diminishes.
The payment of more than your committed amount does work, but today, it's pretty hard to add more to something that is over $2,000 a month.
I feel sorry for the young of today who are trying to get into the housing market.

 

[Wandiwa]

Anyone that wants to play with the numbers to workout their savings on a mortgage by tweaking capital, interest rates or repayments .... Google Amortization calculator, most are very easy to use.

 

[IAN3005]

Interest rates rose to 17% but when they dropped down I continued to pay the same amount. I paid 13 monthly payments and stick my entire salary into a "miser" account and this reduced my mortgage by 10 years, minimised taxes and paid no interest on the mortgage.

 

[Trudi]

Once I have locked into a mortgage, I have never been in a hurry to pay it off quickly. In fact, I have always chosen the longest possible timeframe on the premise that more benefits are gained by locking in the lowest possible price than to worry how much interest I pay over time until the property is either sold or the loan is paid in full.

I still own the property that I had built in Perth way back in 1988 for my 3 teenage kids and myself. While living there I re-married, had another child and divorced all within 3 years. So I packed up and moved to SA, where I bought a little house on the banks of the Murray River, I still own that house too. Later I amoved to NSW, where I purchased a 2 bedroom unit at first and then a 3 bedroom townhouse, I kept those too when I moved to Canberra and had a new house built in 2008 - about 3 years before I retired from work.

All up I had 5 properties for ten years, 4 of which were tenanted and were on interest only loans. I would have it found very difficult if I didn't have interest only loans, given that I was also raising my youngest son.

I have since sold the unit and the townhouse and paid off all mortgages plus have some surplus cash in the bank from the sales. I still own the Perth and SA properties.

Other things to consider are that loans get cheaper over time for no better reason than inflation and in line with inflation income also increases - even if at a lower rate.

 

[RTS]

Compound interest was taught to me at high school.
I worked in a bank and had to manually update savings accounts with accrued interest, when we weren't busy.
I feel very sorry for those people with large mortgages who've had their interest charges more than double in a few short months. The RBA also did this in the late 80s and later could not give a satisfactory reason for raising interest rates to extremes. I hope they'll be held accountable this time.

 

[IAN3005]

You pay almost double the price with interest... the banks (elite rich) get richer while get poorer.

 

[Trudi]

You pay almost double the price with interest... the banks (elite rich) get richer while get poorer.

I look at it this way, you have a choice between paying rent for a house that belongs to someone else or paying "rent" on a loan to pay for the purchase of a house.

The purchase price of a house cannot go up once you have signed a contract to buy and, although at the start of mortgage repayments the bulk of your payment goes to interest, over time the loan decreases at a faster rate while the interest cost reduces (interest fluctuations ignored).

Over the past 35 years I have purchased five properties. I have lived in each of them and all but one have been turned into rental properties when I moved on. I have since sold two of the properties and still own two rentals and my own home.

All of my mortgages are fully paid off and I still own three properties outright. I don't really care about how much I paid in interest over the years, I have gained "renting" money to achieve my financial goals.