R. was pretty insistent about it: by applying the lump sum from my super payout (when leaving my last job) to the mortgage we could save big time. But she couldn’t explain to me exactly why, and I couldn’t really see how paying our mortgage down (currently costing 6.99%) could save us over having the money deposited over in RaboPlus (currently paying 7.35%).
Lucky she insisted, because as I discovered she was absolutely dead right. I think it’s something to do with increasing the proportion of subsequent payments that go to paying principal, rather than interest, creating a virtuous circle where the loan gets paid off a lot earlier, freeing up the loan payments for savings.
You can see this for yourself at sorted.org.nz.
Imagine the following situation: you have a $100,000 mortgage costing 8% which you are paying off at $300 per fortnight. You get a $10,000 windfall. Do you put it in a bank savings account at 7%? Or do you apply it to the mortgage?
Windfall to savings | Windfall to mortgage | |
Paid to the bank in Interest & Principal^{1} |
-$183,340.08 | -$147,829.46 |
Time to pay off mortgage | 22 years 7 months | 19 years 7 months |
Earnings from savings | $46,087.55^{2} | $25,910.25^{3} |
======== | ======== | ======== |
Net position | -$137,252.53 | -$121,919.21 |
In other words, by simply by applying the $10,000 to the mortgage, rather than to the savings account, you’ve effectively generated an extra $15,000 wealth for yourself at the end of the 22 years and 7 month life of the original mortgage. You’d have to find some sort of investment for the $10,000 returning about 8.38% over the 22 years and 7 months to get a similar effect.
And then I nearly forgot the tax issues. You’d be paying tax on the proceeds of the savings account all those years, making the effective interest rate quite a bit lower than the 7% I’ve listed^{4}… whereas, given there’s no capital gains tax on New Zealand (on equity gains in property, at least) the gains made by paying off the mortgage are tax-free. Result: you win even bigger.
So, even if I lost you somewhere up above with all those figures, it seems it pays to take the time and effort to sit down and work it out: Sorted and Excel are your friends. Applying this sort of calculation to our situation R. and I have calculated we’ll be many tens of thousands better off at the end of our mortgage by applying my super payment to it now rather than putting it in a savings account, even given the odd situation we have with the relative interest rates at the moment^{5}.
My new place of work is having an effect on me, it would seem.
^{1} See Sorted’s comprehensive mortgage calculator.
^{2} $10,000 in the bank at 7% for 22 years and 7 months – see Sorted’s lump sum savings calculator.
^{3} The retained mortgage payments ($300 per fortnight) for the period between 19 years, 7 months and 22 years, 7 months at 7% interest – see Sorted’s regular savings calculator.
^{4} Assuming a 33% tax rate on the savings interest, making a real net rate of 4.62%, this would change the savings figures returned to $27,731.01 and $25,037.61 respectively, meaning that the extra wealth generated by paying down the mortgage earlier actually more than doubles to nearly $33,000.
^{5} Of course, this doesn’t take into account the issue of whether or not it’s wise to invest (or in this case, increase your equity) so heavily in property given the suspiciously bubble-like nature of prices at the moment… but you’ll be hard pressed to sensibly diversify until after you pay the mortgage off anyway. And you didn’t think about that when you bought the damn house in the first place, did you?