How much is your house costing you?
One of the biggest misconceptions in personal finance is the cost of various big-ticket items. The largest of those purchases is the home you own.
In standard practice, you’ll put down a deposit, let’s say 20% to mitigate any extra fees by CMHC (Canadian mortgage insurance). The balance of your home is covered by a loan from a financial institution, with the promise to pay back over a set period of time. Many mortgages these days have 30-year payback periods, with fixed interest rates for 5 years.
The question is, how much does that home cost? Let’s use a million dollar home in our example, as the average cost of a home in Toronto is now sitting just above that million dollar mark.
Ignoring costs and taxes, that million dollar home consists of $200,000 paid up front (20% down), and an $800,000 mortgage. At an interest rate of only 2.5%, capitalizing on today’s historic lows in interest rates, with a pay-back period of 30 years.
Plug those values into a mortgage calculator, and you’ll see how much that million dollar home is actually costing you:
With interest on your mortgage, you are paying a whopping additional 34% on top of the cost of the home!
And, that is with today’s exceptionally low interest rates. An increase in interest rates would make that amount much much more.
But all is not lost! There are options that can help save you tens of thousands of dollars throughout your life. This option is called a loan prepayment.
How Does Loan Prepayment Work?
A standard mortgage will always have an allowable amount that you can prepay each year without penalty. Additionally, most car loans are structured the same way.
What this means is that you can pay extra to the bank, in order to reduce your loan principal. The loan principle is the amount you borrow, and that is what the interest is calculated on. By prepaying that principle, you can reduce the amount of interest you pay by a significant amount.
Contrary to popular belief, loan prepayment doesn’t mean making the same payment as your standard mortgage payment, it’s substantially less. Because early in the loan’s life most of your standard payment is used to pay down interest, by pre-paying the principle down, you are able to reduce the total amount outstanding by a significant margin.
Take our example above with the million dollar loan. That work’s out to monthly payments of $3,161. By paying an extra 10% per month, only an additional $316.10, you can save yourself 5% of the purchase price over the life of the mortgage. That works out to just over $47,500 in savings, almost $50K! And the cherry on top is that your home would be fully paid for 46 months earlier (almost 4 whole years).
For a smaller additional payment made each month, you could save yourself almost $50,000 in your life. That’s a sizeable addition to your other savings, and would certainly go a long way towards your other financial goals.
Careful of the Fine Print
Of course, this sounds almost too good to be true. A small additional payment can save you tens of thousands of dollars throughout your life?
The answer is: yes, but...
While your standard loans will allow prepayment, there is a limit to how much you can pre-pay without facing penalties. For some of you that number is 10%, for others its 20%. Before you start sending every spare dollar you have to pay down you loans, make sure that you know what the fine print says. You don’t want to save on interest just to pay the same amount back in penalties!
While most advice on savings says “cut back on this and that”, this advice is different. It’s in a class of its own in terms of wisdom and impact. Pay a bit more now, and you will reap tremendous benefits throughout your life.
The best part is that this advice works for every type of financing arrangement. Pay your car loans off quicker, and you’ll see extra dollars in the bank at the end.
Suffering through slightly more financial pain now, will put you on the path to tremendous financial gains in the future. Your future is in your hands, now you have the tools to make that a brighter place to live.