Even before we started our serious efforts towards financial independence, I nonetheless read everything I came across relating to money. Your typical best-sellers, and some more obscure books and blogs.
Sometimes, those sources held seemingly contradictory advice. One, for example, recommended taking out the shortest home loan possible. Another recommended taking out the longest loan term possible.
Which one is right? Why would two published books – both well-written, popular finance books published in the same country in a similar time frame – give such seemingly conflicting advice?
It turns out to be a case of different horses for different courses, and learning which course is right for you is crucial.
The ‘Typical’ Australian
As a child, I used to read anything I could lay my hands on. As an adult, I usually have six books on the go at any given time. And I almost always finish what I start – even if I don’t enjoy a book.
But sometimes, I know it’s not the right book for me early on.
I knew ‘$1 Million for Life’ by Ashley Ormond was not for me when I read Section 1.1 of Chapter 1 on Page 1, where the author presented a ‘snapshot’ of what he described as the ‘typical Australian family’.
Not only am I not ‘typical’ (nor part of a ‘family’ by Ormond’s definition), but I began to get the impression that the cases described were not necessarily all that typical either.
Ormond says of his reader, you will:
- be between 30 and 50 (we were in our 20s when I picked the book up).
- have 1 or 2 kids (we had none).
- earn $50-150k per annum and live in a house in the suburbs (wrong again. And according to the Australian government, the average household income in the year of this book’s publication, was actually $66,820 – much closer to the lower end of this scale)
- have recently upgraded to a bigger house or renovated, and bought all new appliances (still haven’t).
- live in a house double the size of the one you grew up in (nope again).
- have a home so full of stuff you rent a storage shed (absolutely not. In fact, all of our belongings fit in a single small van).
- pay a cleaner/gardener/pool cleaner/child carer (ha! And really, is that typical?).
- have a couple of cars (including a 4WD), and plan to buy cars for any children for their 18th birthdays (nope – never owned a vehicle).
- send your kids to Catholic or private school (actually, while enrolments in Catholic and independent schools are increasing, the majority of children in Australia still attend government schools, so this can hardly be called ‘typical’).
- own a dog or cat (we’re both allergic!)
- have a wallet full of credit cards (I’ve never owned one in my life)
- possess a mortgage that is growing (why I would be paying installments less than the interest when I apparently have up to $150k at my disposal is beyond me).
This ‘typical Australian’ apparently aims to pay off the mortgage and other debts (don’t have any) pay the kids’ uni fees and buy them cars (don’t have any – and the majority of students in Australia, like I did, borrow money from the government on a no interest loan and pay heavily reduced fees, and can receive an income while studying), help kids get into the housing market and leave them a legacy (why not just give them a copy of this book?) and my favourite, buy a new boat (I don’t even have an old boat – and nor do most Australians – while boat ownership is on the rise, only 11% of households have one of any description).
Assumptions about ‘typical’ willpower
Ormond tends to assume that his readers will struggle with finding the willpower to save money, or to spend it in the most beneficial ways. If the above descriptions rang true to you, his advice may serve you well.
Anita Bell, on the other hand, tends to assume that her readers will be ambitious and driven.
These underlying assumptions inform the different courses of action they suggest when taking out a loan.
Two different courses…
Ormond’s suggestion to take out a loan with a shorter term is based on the assumption that you will probably not make extra payments on your loan, and that you will have a relatively high income and stable job. Because a shorter loan will have higher minimum repayments, Ormond believes this will encourage you to pay off your loan faster than if you took out a loan with a longer term and lower minimum payments.
On the other hand, Bell’s suggestion to take out a loan with a longer term is based on the assumption that you will have the willpower to make payments above and beyond the minimum set by the bank whenever you can, and that you will appreciate a safety net.
Let’s take a look at this advice in practice.
Say you have a combined household income of $65,000 after tax, and you take out a loan of $300,000 for 25 years at 4%. Your minimum monthly repayment is $1,583 (almost $19,000 a year). During this time, you will pay over $175,000 in interest. (Yes, that figure is correct. More than half of the value of the loan. If this isn’t motivation to pay off your home loan as soon as possible, I don’t know what is.)
On the other hand, if you took out the same loan, but for 30 years as Bell suggests, your minimum monthly repayment would be just $1,432 (just over $17,000 a year). During this time, you will pay a mammoth $215,000 in interest. (Even more shocking, right? That’s two thirds of the value of the loan. Meaning you’re not actually paying off $300k, you’re paying off over $500k).
On the face of it, Ormond’s advice looks like a clear winner: who would want to pay $215k in interest when they could pay $175k instead? That’s an extra $40,000 in your pocket.
The trick is, there’s nothing stopping you from paying more than the minimum payments on your loan, other than your means and your own willpower.
Taking out a 30 year loan rather than a 25 year loan doesn’t mean you can’t aim to pay it off in 25 years instead. Or even less. It’s a maximum loan term, not something to aim for.
If you took out a 30 year loan, and paid the extra $152 you would be paying each month had you taken out the shorter loan as an extra payment, you’d still shave 5 years and over 40k off of your loan. It works out exactly the same.
The benefits of having a longer term and a lower minimum payment are that it gives you more flexibility in case an unexpected expense crops up, interest rates rise, or your income goes down.
The only benefit of having a shorter term and a higher payment is that it gives you a strong motivation to pay off your loan somewhat faster – after all, if you don’t, you’ll have the bank knocking on your door.
So which should you choose?
These examples compare someone with the same financial situation (same income, same loan amount for the same asset), and with the same level of financial literacy. Both Ormond and Bell have written very clear, accessible books for a lay audience with very little or no prior knowledge of finance.
The only difference which will tell you which one is right for you is on the matter of spending patterns and willpower.
If, like the kind of person in Ormond’s book, you are on an ‘average’ income and yet aspire to buying several boats, sending your kids to expensive private schools, all the while only making minimum payments on your debt, and buying things you admit you do not need, then his advice is very likely better for you.
On the other hand, if you are more like Bell, who describes going to the lengths of cutting down on TimTams and cooking pet food for her dogs instead of buying store-bought in order to eliminate her mortgage in record time, you might find her advice more fitting.
Both courses can lead to the same outcome – depending on how you run them
With either loan term, you can still meet the goal of paying off your mortgage earlier than the bank stipulates. We took out a loan for 30 years, and paid it off in just over 4.
The important lesson is that advice is not always ‘wrong’ or ‘right’ (although sometimes it is definitely incorrect!!), but often, it is a question of appropriateness. Knowing yourself – your situation, your goals, and being honest about your self-control – is important. Choosing Bell’s advice merely because you aspire to being more frugal might sound like a good idea, but you may end up falling short of your goal unless you find some other way of motivating yourself. Likewise, choosing Ormond’s advice if you need a safety net could be dangerous. Understanding your own money personality – and the personalities and language of those you make financial decisions and communicate with – can really help.
I am not the ‘typical Australian’ and odds are, you aren’t either. I don’t think the ‘typical Australian’ (or the typical American, or typical Armenian, or typical Afghanistani, or typical Argentinian, for that matter) really exists.
And that’s okay.
One of the beauties of reading widely is getting to weave together your own narrative. In the next post, we’ll take a look at writing your own script.
Do you struggle with finding the willpower to save? Find out how to get rolling, and maintain your money mojo. Or are you financially ambitious? Let me know in the comments!
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