Updated: Apr 30, 2019
Most of us look at debt as something bad. While it is human nature to hold off paying debts quickly, the more prudent amongst us prefer to reduce debts as quickly as possible.
And rightly so.
However, trying to pay off your mortgage before the pre-agreed tenure, could actually be a bad idea.
In this post, I will breakdown a mortgage for you so you get a better understanding of how it works and why you should hold-off the urge to get rid of your mortgage before its term.
Get your thinking cap on and put away distractions because we're going to be crunching numbers. It will be well worth your time and you'll never look at mortgages in the same way again.
What Is A Mortgage?
A mortgage, more commonly referred to as a home loan in Malaysia, is different from an interest-only loan because it is amortised. Huh? Yes, that's what I said when I first learned this in business school.
An amortised loan means that you pay a fixed amount over a period of time and these payments offset both principal and interest. In contrast, an interest-only loan means you pay interest only over a period of time and at the end of the duration, you will have to pay the principal in one lump sum.
It becomes immediately obvious that an amortised loan is safer because you don't have to pay the principal in one large repayment. Imagine borrowing RM800,000 on an interest-only term for 30 years. At the end of the 30 years you'd have to fork out RM800,000 as final settlement. Not everyone would have such a substantial amount lying around in cash.
Therefore, banks reduce their credit risk by amortising loans.
You also end up paying less in interest.
If you borrowed RM800,000 on a 30-year term with an annual interest rate of 4.5%, you would pay RM659,254 in interest if the loan was amortised. If the loan was not amortised, you would pay RM1,080,000 in interest. You save a cool RM420,746 with an amortised loan. Not bad at all, right?
The only problem with an amortised loan is your monthly payments are significantly higher. This is because you're paying the interest and principal off at the same time.
For the same example above, you would pay RM4,053 per month if the loan was amortised. If it was an interest only loan, you would be paying RM3,000 per month. If you invested in a rental property, having to pay less every month could mean a positive cashflow.
Another feature of an amortised loan is that the payment ratio of principal to interest changes over time. You start of paying more towards interest and towards the end of the term, you will be paying less. Conversely, you pay less towards the principal in the beginning and more towards the end.
Still on the same example above, your first payment of RM4,053 would comprise RM1,053 going towards the principal and RM3,000 going towards interest.
At the end of the loan period, RM4,038 would be paid towards the principal and RM15 towards interest.
How Is An Amortised Loan Calculated?
There is a formula and it is as follows:
The interest payments every month is calculated by multiplying the monthly rate with the balance owed. Therefore, payments towards interest reduces every month.
The formula for calculating payments on an amortised loan is FIXED. This means it does not change from lender to lender. In Malaysia, AmBank all the way to UOB Bank will calculate your mortgage using this same formula. There is no secret or proprietary calculation methods as some people may claim. Oh yes, I've come across such claims.
And because the amortisation is calculated on number of periods, there is no significant difference if you pay your monthly instalments sooner in the month. For example, if your due date is the 29th of every month, you most likely gain no advantage by paying on the 15th of every month.
However, you may get penalised for paying late as banks have late payment penalties.
The Beauty of A Mortgage
When you take a mortgage on a property, you are leveraging. Leverage simply means you are using money you don't have at present to buy an asset.
Your return is amplified when this asset appreciates because you did not have to fork out 100% of the asset value to purchase it.
Sounds a little complicated?
Let me break it down for you.
We're still using the same example above. Let's assume that the property's selling price was RM888,889. You pay 10% towards the property which amounts to RM88,889.
The balance RM800,000 is financed through a loan. Assuming you do not fork out any more of your own money for this property, you only had to come up with the 10% downpayment to own this property.
But when the property appreciates in value, the appreciation is not on the RM88,889 that you come up with. The appreciation is on the total value of the property which is RM888,889.
A 5% appreciation on this property after 1-year would mean that the property value is now RM933,333. If you sold this property on the 1st year, your return after paying off your mortgage would be RM147,341.
You put up RM88,889 to get RM147,341. Your net profit (RM147,341 - RM88,889) is RM58,452. Your ROI is 66% although the property only appreciated by 5%. That's the beauty of leveraging and it is one of the primary reasons that a mortgage is advantageous, especially when you are buying to rent.
If you buy to own, then a mortgage is not very advantageous if you don't intend to stay in the property long term. You can see how this works by running comparisons using my Property Investment Calculator.
Do note also, that leverage can work in the opposite direction and magnify losses.
Why Is It A Bad Idea To Pay Off Your Mortgage Earlier
Some people want to make extra payments towards their mortgage so that they can reduce the tenure. The idea is that if they make over-payments towards the principal, the loan term reduces from say 30 years to 20 years and they pay less in interest. They also become debt free faster.
On the outset this makes good sense. However, you need to look deeper.
Besides giving you the advantage of leverage, mortgages give you another advantage.
Inflation is often overlooked in property investment but you definitely want to look at it now.
When you take a loan of RM800,000 to buy a property today and you are allowed to pay it over a 30-year period you are in an advantageous position in the context of inflation. This is because RM800,000 today is worth a lot more than RM800,000 30 years later.
If we factor Malaysia's 46-year average inflation rate of 3.55%, RM800,000 today is worth RM2.28 million in 30 years.
Because you pay off the mortgage gradually over a 30-year period, the math is a little bit more complex but an RM800,000 loan payable on a 4.5% interest over 30 years with inflation at 3.55% has a Present Value of RM1.44 million.
Inflation also means that the monthly instalment you pay is actually becoming less and less over time. So the big question is this; why would you want to pay off your principal in the future using today's money which is in fact more expensive?
“To save on the interest,” some might argue.
Ok, but there are three other things you need to consider. First, your mortgage is not necessarily your highest interest loan. Your credit card is much higher. Which means you are better off reducing credit card and other debts that cost more in interest.
Second, there is an opportunity cost.
Let's simplify now. Let us assume that you pay an additional 1 month towards your principle in the first month. So, instead of paying RM4,053, you pay double which works out to RM8,106. What you have saved is RM11,402 in interest after 29 years and 9 months.
If you took that RM4,053 and invested in a REIT giving an average 5% per annum. You would have RM16,683 after 29 years instead of RM11,402. That is a net gain of RM5,281.
This is compounded every time you over-pay to reduce your loan tenure. If you paid an additional RM4,053 every year from the beginning towards your mortgage, you would reduce the tenure to 25 years and 9 months. You would also save RM106,793. in interest.
If you invested the same amount every year in a REIT paying 5% per annum, you would have RM231,932 in 26 years. That is an opportunity cost of RM125,139!
Third, you save less in interest if you start over-paying late into your mortgage term. For example, if you over-pay RM4,053.48 in the first year of your mortgage, you save RM11,402 but if you overpay RM4,053 on the 15th year of your mortgage, you only save RM3,853. This is because your are paying less towards interest and more towards principal over time.
Do you see how you lose out in a significant way?
What If You Still Want To Reduce Your Mortgage Term
You can by over-paying. First ensure that the extra payments you make go towards reducing the principal sum borrowed. Clarify this with your bank.
Once you have clarified with your bank, you can overpay using one of the strategies below:
Still using the same example, let us assume your monthly instalment is RM4,053. Divide this by 12, and you get RM337.75. Add this to your monthly instalment. So every year, you are paying 13 months. This will reduce your mortgage by about 4 years 4 months.
Divide the monthly payment by 2 and pay exactly every 2 weeks starting from your due date. So in this example, you will pay RM2,026.50 every 2 weeks. Because you have 52 weeks in a year, by the end of the year you would have paid one additional month, thereby reducing your mortgage by 4 years 4 months again.
This method is more expensive. Overpay an additional instalment every quarter. This means you are making 3 extra instalments every year which reduces your mortgage term by almost 10 years.
You can also use this online mortgage payoff calculator to simulate different over-payments.
Please note that your bank may charge you over-payment fees which could then negate the over-payments you are making. Before embarking on any over-payment, clarify with your bank limits and ensure over-payments are offsetting the principal.