When should I pay off my mortgage?

The typical mortgage in Australia comes with a 25 or 30 year term. But that doesn’t mean you should aim to pay off your mortgage over a three decade period.

The end date on your mortgage document is like a speed limit.

It’s not something to aspire to. It’s something you should try to stay well under.

Nowadays, the average first home buyer in both Australia and the US is  31 years of age, with 57% of first home buyers in Australia in their 30s or even 40s.

If you were to take out a 30-year mortgage at the age of 31, and simply pay the minimum, you’d be paying it off until you’re 61. This leaves you just 4 years to concentrate on retirement savings if you’re planning to leave work at 65.

On the other hand, if you were to take out a 30-year mortgage at the age of 41, again making minimum payments, you’ll be stuck making payments until you’re 71. That’s well into what most people would consider their retirement years.

The fact is, the average retirement age for those over 45 (i.e. those who did not retire truly early) is 54 years old. Meaning that either scenario above will involve you either having to work longer than many of your peers, or find some way to pay the mortgage without a salary.

Most people sell and buy again

And when we consider that these are just first home buyer ages, the matter becomes even more alarming. Most people sell (before getting close to paying off their original loan) and buy again. The average age of someone purchasing their second home is 51. This means a 25 or 30 year mortgage will have them making payments right up to the age of 76 or even 81. And those ages aren’t just a long way past the typical retirement. The average male may not even live to the age of 81.

Given that many first home buyers are now coupled and often have kids well before they buy a home, perhaps they are buying their dream home at the outset, and won’t feel a need to ‘upgrade’ later. Anecdotally, looking around at my friends and contemporaries, while a few have decided to purchase smaller townhouses or what some would view as ‘starter’ homes. But the majority have chosen to wait until they had a deposit for a large family house. And family houses in Australia certainly are large – we might view American homes as being enormous, but Australian houses are 10% larger – and 9% larger than those in New Zealand.

Refinancing

Yet even if you stay in the one house for life, many homeowners refinance their mortgages every 4.5 years. Refinancing can be an excellent decision, potentially saving you thousands over the lifetime of your loan when moving to a loan with a lower interest rate.

Let’s say you’re a 31 year old who decides to take out a 25 year loan of $500,000 at 5.5%. Your minimum monthly repayments are $3,070.44. If you keep up those payments, and don’t make any extra contributions, you’ll be on track to pay off your mortgage around your 56th birthday. After around four and a half years, you start looking to refinance. You find a better deal, 5%, 0.5% less than your original loan. Woo-hoo!

For simplicity, let’s say you refinance on the 5th anniversary of your loan, when you have $446,3578 in principal remaining.

Your new loan has minimum payments of just $2,609.36. That’s a whole $461.08 per payment, or over five grand per year lower than your old deal. High five!

Except… wait a minute!

Not all of this saving is attributable to the half a percent less you’re paying in interest.

A big chunk of it is due to the fact that you have just extended the lifetime of your loan.  Or, put another way, you’ve taken out a new 25 year loan for a lower sum this time. You’ll now be paying it off until you’re 61, not 56.

Your refinanced mortgage is for $446,357.63, not $500,000. And it’s likely for another 25 years, not the 20 you would otherwise have remaining if you’d stuck to your old loan. Otherwise, this deal wouldn’t look near as sweet.

If you want to keep on track and pay off your home by 56, not the new end date of your 61st birthday, you’ll need to contribute more than the bank demands.

To pay off the same amount of money in 20 years, not 25, you’d need to make minimum payments of $2,945.77. That’s still a $124.67 saving compared to your old deal. But it’s nowhere close to the $461.08 figure a banker or mortgage broker might try and tempt you with.

Why would the bank want to keep you in debt for longer?

It’s simple. They make more money off of you.

If you pay off $446,358 at 5% over 25 years, you’ll wind up lining their pockets with $336,451 in interest.

If you pay off the same sum, at the same interest rate, but making higher payments so that you can pay it off in 20 years instead of 25, you’ll only have to hand over $260,626 in interest. That’s a difference of $76,189.

Why would your broker want to keep you in debt for longer?

It’s simple. They make more money off of you.

Every time you take out a mortgage or refinance a loan through a broker in Australia, they receive an upfront commission. If you refinance the loan within 4 years, they must return it. This explains why many brokers suggest refinancing around the 4.5 year mark.

They also receive a trailing commission that lasts the lifetime of the loan. Unless it is refinanced to someone else, in which case, their stream of income will cease, and the new broker will receive it instead.

Because people are likely to look around for better deals, because they’re afraid of losing your commission, because it’s in the broker’s interest to extend the lifetime of your debt and receive as long an income stream as possible – and also because they genuinely do want a better deal for you – brokers may recommend you refinance your mortgage.

Should you avoid refinancing?

Not necessarily.

Refinancing, as we’ve seen above, can save you a lot of money. There may be other fees and charges involved that you need to take into account, but generally speaking, a lower percentage rate is a good thing when it comes to debt.

The important thing, however, is you should try to keep your payments at or above the level you were previously paying. If you worry you don’t have the discipline to do this, set it up as an automatically occurring extra payment.

To take the previous example, if you have a loan of $446,357.63, and you keep paying your original payments of $3,070.44 per month ($461.08 more than the bank now demands) you will save a whopping $95,538.49. And you’ll pay off your loan 6 years and 4 months earlier than the bank now expects – which is 1 year 4 months earlier than originally planned! Meaning, instead of paying off your mortgage by 56, you’ll have it done and dusted before your 55th birthday. And this is without having ever paid a cent above your original minimum payments.

So refinancing can be a great thing – IF you fully grasp it as an opportunity to improve your finances, rather than take the easier route of simply contributing less to your debt.

What about brokers?

Again, not necessarily.

We have had the experience of purchasing a home through a broker, and purchasing an investment property directly negotiating with the bank. In the first situation, the broker was recommended by our real estate agent (big mistake!) after our initial agreements with our bank fell through. Unfortunately, he was not used to dealing with first home buyers. As a result, the application his office sent in was incomplete, causing us all kinds of hiccups.

The right broker can help you through these kinds of things. And they may even be able to get you a better deal than you could find on your own. I say ‘may’ because brokers are only able to obtain loans from those institutions they have relationships with. Any broker will only be as good as their list of lenders, and their ability to determine your needs. If you aren’t confident researching or negotiating, or lack time, a broker can be a very good ally. And even though they are working for commission, so is the bank’s loan officer. It’s just that they have only one lender in their panel, and the responsibility to compare lies with you.

An important question

Whenever you’re considering refinancing, it’s vitally important to understand how much of the ‘saving’ is a function of the lowered interest rate, and how much is a function of the extra time the new loan may assume you will take to pay it out.

Set your own target

Whether you have refinanced your mortgage or not, the term of the loan is not a target. It’s not something to aspire to.

It’s like the speed limit.

I’m often frustrated by drivers who, caught speeding, say ‘Oh, but I was only a bit above the limit’. The same is true of drunk drivers only ‘a bit above the limit’. Or, in my old career, the students who were only a ‘few minutes late’ handing in an assignment they’d had until midnight to submit online.

60 km/h is not a TARGET.

Nor is 0.05 blood alcohol content.

I never awarded extra points for students who submitted on the stroke of midnight.

Those are upper thresholds, limits, the absolute MAXIMUM permissible, and you should treat your mortgage the same way.

Likewise, the maximum amount your lender will loan you is NOT the target of what you ‘should’ aim to spend either. As I’ve said before, it’s not an all-you-can-eat buffet. It is an absolute maximum upper limit. You should be aiming well below that figure to give yourself some safety. The ability to borrow more if unexpected expenses crop up. The ability to easily make your payments even if your income unexpectedly goes down.

A confession…

I have to confess that although I have written this post about refinancing, I’ve never actually done it myself. Why?

Simply because both mortgages we took out, we paid back in less than the four and a half years it normally takes for a broker or bank to approach you.

How did we do this? For starters, we didn’t buy a large family home.

In this post, I’ve used $500,000 as an example since average house prices are now getting up around this range, and because it’s a nice round number.

I wanted to illustrate what buying a big house and paying it off slowly can do to your enjoyment of life, and your retirement plans.

But you certainly don’t have to spend that much.

We spent less than half of this sum, which allowed us to get a foot on the property ladder much younger than usual (at 23 and 26). More importantly, it enabled us to own our home in full before most people have even signed their first loan (at 27 and 31). You can read more about our journey, or strategies for saving a deposit and paying off your mortgage fast.

A much better target

Anita Bell’s fantastic book Your Mortgage: And how to pay it off in five years or less does exactly what it promises. It includes tables that will help you determine exactly how much you can afford to borrow if you, too, want to be mortgage free in under 5 years.

Imagine fully owning your own home by 36 instead of 56. What would that free you up to do?

The family home is most homeowners’ biggest asset when calculating net worth. But it isn’t an income-producing asset for most people. Spending less on your place of residence might free you up to improve your net worth in other ways. Perhaps you could buy an investment property, or investing in a managed fund. Rather than entering your retirement years with a mortgage, you could have diverse income streams.

In the next part of this series, we’ll look at two alternate realities. What happens when you retire with a mortgage, and what happens when you retire with income-producing assets.

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