How to Cut Spending in Half and Pay Down Your Mortgage Sooner

May 20th, 2009

I hate debt. Always have. In an ironic, self-loathing twist, I spent several years working as a mortgage specialist with a large bank. The benefit of this experience is that I learned all the tricks to saving money on a mortgage. I also learned that a mortgage makes all your needless purchases cost twice as much. Here’s why, and how to stop it.

The Cost of a Typical Mortgage

If you calculate the cost of a typical mortgage:

• 5-6% interest rate
• 25-30 year amortization

You will find that the bank charges approximately $1 of interest for every $1 borrowed, over the life of the loan. So a simple way to look at typical mortgage costs can be:

$1 borrowed = $1 in interest

When people see “5% interest” they often erroneously assume they’re only spending 5 cents on the dollar to borrow. This is simply not true with mortgages since their interest charges compound over decades, ballooning to a much larger amount. Of course, different interest rates and payment schedules can change these numbers, but statistically speaking this ratio applies to most people.

Realities of Mortgage Costs

Using this calculation, it is very easy to see how much a home purchase will approximately cost, provided you make only the required minimum payments.

For example: Buying a $250,000 home will require an additional $250,000 in interest payments to the bank. Total cost to pay off the home in full: $500,000.

Although it is staggering to think our homes actually cost twice as much, we can use this ratio to our advantage as a mental tool to encourage debt reduction.

Making additional mortgage payments saves you drastic amounts of money. These additional payments go by many names: “prepayments”, “lump-sum payments”, “privilege payments”, but I prefer “mortgage kryptonite”, since they dramatically reduce the power of interest charges.

By extension, this calculation can be applied to any frivolous or unnecessary expenses.

For example: A dinner at a restaurant totalling $50 actually costs another $50 in interest. Why? Because you didn’t opt to pay down $50 of principal on your mortgage, you continue to accrue interest on that amount. Total cost of your $50 dinner: $100.

If, rather than spending money at that restaurant, you applied those $50 to your mortgage, you would save the same amount in interest charges. You’d be mortgage-free a little sooner too.

So the mental tool can be stated as follows:

When you have a mortgage,
any unnecessary purchase costs twice as much.
Pay down your mortgage instead.

Of course, this takes some of the zest out of life. Where you might have spent money on something fun, this encourages you to make a rather bland mortgage payment instead. Nevertheless, your mortgage will be paid sooner, freeing up your regular mortgage payment for fun stuff earlier. In a sense, making additional mortgage payments provides more “net fun” over the course of your life as a whole. The party that looses most is the bank.

The “I want it now, I’ll pay for it later” mentality doesn’t do much good for the economy as a whole, and it won’t do you any favours either. There’s no better time than the present for a little debt reduction and this way of looking at mortgages may help you do just that.