Last week I wrote about the importance of getting control of your home loan, both to pay less interest and to give yourself a safety buffer if you strike a financial challenge. I pointed out that, because of the way compound interest works, once your payments are at a level to pay your mortgage off in 10 years, there is little to be gained by paying it faster.
A reader asked why they should ease up on the payments when they got to 10 years - surely, they reason, getting the mortgage totally paid off is the best way to go.
I understand the logic, but there is another factor at play: the importance of time in wealth creation.
For example, if you had a loan of $300,000 at 3% and were paying it back over 30 years, the monthly repayments would be $1265. If you bumped those repayments up by $704 a month - to a monthly total of $1969 - you would slash 14 years off the loan and cut the term back to 16 years. But to chop 25 years off it, reducing the term to five years, would require monthly payments of a massive $5391.
Let's think about two couples who are willing and able to set aside such a large amount. The Smiths and the Browns are aged 45, owe $300,000 on their home, and are in the 39% tax bracket including Medicare.
The Smiths are of a nervous disposition, so they decide to pay their mortgage off in just five years to provide security. This requires monthly payments of $5391.
The Browns are also willing to pay $5391 a month towards their future prosperity, but they are happy to adopt my 10-year strategy and pay their mortgage back at $2910 a month. This leaves them with $2776 of after-tax dollars to invest. Note that the equivalent in pre-tax dollars is $4553.
In addition to their mortgage, the Browns take out a $300,000 home equity loan for an Australian index fund, which requires tax-deductible interest-only payments of $1000 month. A home equity loan means no margin calls, and an index fund cannot go broke.
They also salary sacrifice $1250 per month each into superannuation. Notice that this choice uses pre-tax dollars, increasing their total investment by $724 a month. This could increase their combined superannuation balance by $1.2 million at age 65.
At age 55 the Browns have paid off their home loan - they then have the privilege of deciding where to invest the $2910 a month house payments no longer needed. They decide to pay off the home equity loan so they will be debt free when they retire in 10 years.
When they turn 65, their managed funds may be worth $1.1 million, if earnings average 7%, and they have extra superannuation of $1.2 million. In this case, they would have achieved a total joint portfolio of $2.3 million in addition to their employer super.
Now let's return to the Smiths. They were debt-free at age 50, but had just 15 years left to invest. Remember that time is one of the biggest factors in wealth creation. Because they had five years less time for compound interest to work its magic, building a portfolio of $2.3 million is virtually impossible.
I appreciate that what I have written about today is just one of many strategies available to build wealth. The main point is to start as soon as possible.
Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. firstname.lastname@example.org