Monthly Archives: July 2017

Mortgage , , 5 Comments

Understand Interest & Principal on Your Mortgage Payment

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Do you know how much interest you are paying on your mortgage? No, I am not talking about the interest rate. How much interest in the dollar amount you are paying on your mortgage? Also, what proportion of your mortgage payment goes to interest? Do you know how many years it will take to pay off half of your mortgage? (spoiler: more than 20 years with 5% interest rate)

Most home owners know their mortgage payment like the back of their hand, but not all of them can tell you how much interest is in the payment. Some new house owner is surprised when they read the mortgage statement and found out how little money went to mortgage repayment. Let’s look at the interest and principal on our mortgage payment. I will be focus on the simple interest mortgage with a fixed interest rate and fixed payment amount for 30 years.

Interest and Principal

Every mortgage payment in New Zealand will contain Interest and Principal.

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The principal is the part of your mortgage payment that goes to repay the amount you borrowed. It starts out with a small amount and increases on every payment. Eventually, the total principal paid will be equal to the amount you borrowed.

The lender (usually Bank) took up risk to borrow you money on a house purchase. Interest is the reward for taking that risk. They are profit for the lender and expense for the borrower. Interest rate could be different for each different borrower. Usually, a low-risk borrower will have a lower interest rate compared to a high-risk borrower. At the lender’s point of view, to take a higher risk borrower, they will charge higher interest to compensate that risk. A significant amount of mortgage payment will go to interest payment at the beginning of the mortgage and decrease on every payment.

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Proportion of interest and principal on a 5% interest, 30 years mortgage

How Much Interest you are paying?

We will use the following simple interest mortgage as an example.

Mortgage size: $500,000
Term: 30 years, pay monthly
Interest rate: 5%
Monthly payment: $2,684.11

For your first payment, $2083.33 will go to interest and only $600.77 will go to principal payment. That’s 77.6% of your monthly payment go to interest expenses.

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Breakdown on your mortgage payment during the first year

For the first year, you will pay $32,209.30 in mortgage payment, $24,832.47 will go to interest, and you only reduce your mortgage by $7,376.83.

Why most of your payment went to interest in the beginning?

You may be surprised only 23% of your mortgage went to principal payment and wonder why most of your payment went to interest in the beginning. I was angry and thought it wasn’t fair. So I dug in and worked out how the banks come up with that amount.

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First, under the terms of the mortgage, interest is calculated daily and compounded monthly. What it meant was the bank will charge interest on the mortgage every day and recalculate the mortgage amount and interest every month. The interest rate (5% here) is an annual rate, so one day of a 5% interest will be 5% / 365 = 0.013699%. Bank will apply that one-day interest rate to your current mortgage amount $500k. At your first month, you will be paying $500000 x 0.01369% = $68.49 every day on interest. Here is the daily breakdown on the first month of the mortgage.

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You may notice on 31/7, the interest amount is only $28.54. The reason is that when we calculate the monthly mortgage payment, we are not calculated based on how many days in a month. We just divided the full year (365 days) by 12, so every payment got 30.41667 days. That’s why I have to re-adjust the 31st day of July interest by 0.41667. $68.49 x 0.41667 = $28.54.

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On 31/7, you pay $2684.11 for your mortgage. At this point, the total interest is $2083.33, only $2684.11 – 2083.33 = $600.77 go to reduce the $500K mortgage. At 1/8, your new mortgage amount will be $499,399.89 and you daily interest will be $499,399.89 x 5% / 365 = $68.41. At the end of the month, we will accumulate $2080.83 in interest. By paying the same amount of mortgage payment ($2684.11), you will reduce the mortgage by $2684.11 – 2080.83 = $603.28.

When you compare the numbers on both months, your monthly payment amount is the same. Since you reduce the mortgage amount by a little bit in your first payment, the interest on the mortgage at the 2nd month will be reduced. That explains the interest payment will keep decreasing and principal payment keeps increasing. The reason we why most of your payment went to interest payment is because your mortgage amount is high in the beginning. Lots of interest was charged and most your payment went to pay off those interest.

How does pay extra on your mortgage reduce the interest calculation

In my last post, I said one thing you can do to reduce the interest paid on your mortgage is by paying extra on the mortgage. Let put that in our example and see how $100/month extra can reduce the interest.

The first month will be the same as we haven’t made any payment. We will still have $2083.33 interest needs to pay. However, if we increase the monthly payment to $2183.33, we will reduce the mortgage amount by $2183.33 – 2083.33 = $700.78. On your second month, the new mortgage balance is $499,299.22 and the daily interest will be $499299.22 x 5% / 365 = $68.40. At the end of the month, we will accumulate $2080.41 in interest, $0.42 less.

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You may think that just $0.42, hardly make any difference. However, that is the saving on the second month only. You will save more and more each month. Paying extra on the mortgage will have a knock on effect on the mortgage amount reduced. You will end up pay off your mortgage in 27.6 years and saved $42.6K on interest.

Breakdown interest paid by years

Now we took the $500K mortgage break it down by years. Here is what you will pay over 30 years.

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Some interesting facts here:

  • 77% of your first-year payment went to interest.
  • By the end of the mortgage, you will pay $500K on principal and $466.3K on interest. You almost paid twice on your mortgage.
  • For the first 16 years, over 50% of your payment will go the interest.
  • You will pay almost half of the total interest on the mortgage in your first 10 years. Therefore, lenders make half of their profit in 1/3 of the time.
  • After paying 20 years, you still owe over 50% on your mortgage.
  • You will pay off $253K in the last 10 years of the mortgage.

That’s why Bank love mortgages, and it’s their bread and butter. I personally feel angry reading those facts. I put reducing mortgage as my top financial priority. On the other hand, inflation is another factor helping to reduce the ‘real’ cost of the mortgage, we will get into that in another post.

If you want to find out the breakdown on your mortgage payment, you can check out this mortgage calculator on mortgagerates.co.nz.

Email thesmartandlazy@gmail.com or follow me on Twitter @thesmartandlazy if you have any questions.

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Mortgage , , , 1 Comment

Understand the Math of Mortgage

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I spent a lot of time here talking about investing in New Zealand. However, if I put my money where my mouth is, I spent more money on reducing my mortgage compares to investing. So let’s take a break from investing and talk about the mortgage, which is one the top three investment options in New Zealand.

We are one of the lucky ones who luck into a house before house price went batshit crazy between 2013-2016. However, since we brought Auckland, the mortgage amount is still huge dispute we put down more than 20% deposit. So reducing that mortgage have been my top priority and I spent a lot of time to research and study on mortgages. It turns out the mortgage is just a mathematical formula. If we understand the factor of that formula, how to pay off the mortgage early is not a secret at all.

The Formula of Mortgage

A mortgage is a loan to buy a property. You borrow money from the lender (usually a bank), and you are obliged to pay back with interest. The lender uses the property as security. Here is the formula of Mortage.

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A is the payment on each term.

L is the mortgage amount (or Principal)

r is the interest rate

n is the term

So the mortgage formula based on those four factors and they are interconnected. If you follow the mortgage plan and make the payment each term (usually every fortnight or month), by the end of the term, you will pay off the mortgage and plus interest.

(You don’t need to calculate the mortgage on your own. There are hundreds of mortgage calculator online, I recommend the Mortgage Calculator on Sorted)

Interest and Principle

Each mortgage payment will have interest payment and principal payment. The principal is to repay the amount you borrowed, and interest is profit for the lender. At the beginning the mortgage term, most of the payment went to interest, and only a small part of the payment went to the principal.

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To work out the total interest paid on the mortgage, you will need to:

Payment amount X No. of Terms = Total amount paid

Total amount paid – Mortgage Amount = Total Interest Paid

The Game of Mortgage

 

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The mortgage is a game with four controls.

For me, the mortgage is just a game. It’s a game with 4 controls. The goal of the mortgage game is to minimise Total interest paid by changing payment amount, mortgage amount, interest rate and terms within your abilities. In New Zealand, the size of the mortgage can be range from $100k to $1mil or more. Total interest paid on the mortgage can be 30% – 130% of the size mortgage. This is a high stake game with $30k to $1.3mil of interest to be saved. Yet, the rule of the game is surprisingly simple!

We are going look into each factor and see how they affect our goal to minimise our total interest paid. We will be using the following mortgage as our default example. To keep it simple, I assume interest rate will stay the same during the whole period.

Mortgage size: $500,000

Term: 30 years, pay monthly

Interest rate: 5%

Monthly payment: $2,684.11

Total Interest Paid: $466,278.92 (93% of mortgage size)

Mortgage Amount

The mortgage amount is the main deciding factor in a mortgage. The amount you borrowed is in direct proportion to your monthly payment and total interest paid. More you borrow, more you pay every term and more paid on interest. However, the size of total interest paid compared to mortgage amount reminds the same. In our example, no matter the size of the mortgage, you are still paying 93% more on interest.

In most case, you want to borrow as little as possible.

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5% interest rate and 30 years term, pay monthly

Interest rate

Interest is charged by the lender to the borrower to offset the risk of lending money. It calculated based on interest rate. Interest rate change from time to time due to multiple factors, including official cash rate change by RBNZ,  the cost of borrowing at the lender, the length of the fixed term, demand of mortgage at each lender and more.

Increase interest rate in a mortgage formula will affect mortgage payment and total interest paid. If you took a 5% interest rate and increased that by 0.5% to 5.5%, the mortgage payment will increase by 5.8% but the total interest paid to mortgage ratio jump from 93% to 104%. So you want your interest rate as low as possible.

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$500,000 Mortgage, 30 years term, pay monthly

 

Terms & Payment

The term is how long the mortgage supposes to last and payment is how much you will pay each time. I put them together because they are closely connected in a mortgage. If we increase the mortgage terms, the payment amount will be lower but you will pay more on interest. On the other hand, if we increase the payment amount, we will shorten the mortgage terms.

In the table below, you can see if we shorten the mortgage by increase our payment amount, we will be paying a lot less on interest.

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$500,000 Mortgage, 5% Interest Rate

 

In Reality, What can you Change?

Now we understand those four factors of a mortgage and how they will affect the end game (a.k.a total interest paid). Let’s put them into a real world situation and see how we can change them to our favour. (There are many ways to improve those factors, I only covered the obvious one here)

Reduce Mortgage Amount

Since the mortgage amount decides your term payment and total interest paid, it’s better to have a smaller mortgage. With small mortgage amount, it will come with a small monthly payment amount. You can increase the monthly payment amount without adding pressure to your living budget.

To reduce the mortgage amount for potential house buyer, you will have to put down a larger down payment or choose a cheaper house.

For existing homeowner, you can reduce the mortgage amount when you mortgage terms are up for review by transfer some of your saving to repay that mortgage. (if you have the spare cash)

To be honest, it is difficult for both potential buyer and house owner to reduce their borrowing amount. With those crazy house price these days, most of the potential buyers are stretching to the maximum on what they can borrow and get onto the property ladder. Existing homeowners are already stuck with that mortgage and lender don’t like you pay them back early. So in reality, you don’t have much control on that.

(There are some tricks to reduce that mortgage with right mortgage set up. We will get into that in an upcoming blog post)

Get a Better Interest Rate

Bad news, you don’t have much control on interest rate either. The Interest rate set by the lender and each lender will have the identical interest rate. What you can do is make yourself a better borrower.

Banks love mortgages as this is their bread and butter. If you are a good borrower in their eyes, they will offer you a discounted interest rate to get your mortgage business. What consider a good customer from the Bank:

  • Owner Occupied Property, mean the mortgagor live in that property
  • Work full time with a stable income
  • Employed by established company for a long time
  • Clean credit history
  • No other debt
  • DINK (Double income, no kids)
  • New Customer
  • Willing to change your ‘Main Bank’
  • Have 20% or more equity in the house
  • A good quality house in a good location (not leaky home or potential leaky home)

Bank will consider that as a low-risk lending and happy to offer a small discount on the interest rate.

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However, the free-market is still the primary deciding factor on the interest rate so there is not much we can do about that. Kiwis used to pay 18% interest rate in 1985. Before GFC in 2008, the mortgage rate was around 8.4%. We are experiencing a historic low in interest rate at 2017.

Increase Payment Amount & Shorten the Terms

Payment and terms are the most important factor in the game of mortgage because we have control over it. When the bank says you need to pay $2684.11 for your $500K mortgage, it’s not the absolute amount! It’s just the minimum amount you’ll need to pay. You can always tell the bank you what to pay more. Let’s see how the term and total interest paid change when we pay more on our mortgage.

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$500,000 Mortgage, 5% interest rate. Minimum monthly payment at $2684.11.

By simply put $1/day extra into your mortgage payment ($30/month), you will shorten the mortgage by 9.6 months and save $13.8K on interest. If you can add $10/day extra into your payment, you can pay off your 30 years mortgage in 24 years and saved $106,644 in interest.

It may be hard to do in the first couple of years, but your income will likely to be increased while the mortgage payment stays the same. Combine that with careful budgeting and frugal living; you can put more and more into your mortgage and reduce the interest paid.

The Secret of Paying off Mortgage

Now you understand the four factors of the mortgage and how you can improve them. The secret of paying off mortgage fast and win the game of mortgage is very simple.

Get the smallest amount of mortgage with the best interest rate discount, pay it off with the biggest payment amount you can afford.

That’s the fundamental principle of getting out of debt; it does not only apply to the mortgage but other consumer debt as well. Every single tips and trick that help you pay off mortgage fast will always chase back to this principle. We will cover lots of them in the coming months. Stay tuned.

Email thesmartandlazy@gmail.com or follow me on Twitter @thesmartandlazy if you have any questions.

Debt, Investing, KiwiSaver, Mortgage, Personal Finance Basic , 6 Comments

Top 3 Investment Options in New Zealand

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I spent a lot of time on my blog talking about ETF and index fund investing in New Zealand. I believe they are great options and an import investment vehicle to help me achieve financial freedom.

However, there are three investment options are objectively better than ETF and Index fund with low entry requirement, low risk and high (sometimes guarantee) return. They are the low hanging fruit of personal finance that everyone should do it. Those three investments options are pay off consumer debt, join KiwiSaver and reduce the mortgage. I will go through each one of them and talk about they risk and return.

No.1 Pay off Consumer Debt

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You want to kill those consumer bills ASAP!

Credit card debt, car loan, payday loan, personal loan, hire purchase, P2P loan… All of those are consumer debt. Debts that are owed as a result of purchasing goods or services that are consumable and do not appreciate in value. Those debts usually have high-interest rate and exorbitant admin fee. If you are paying interest on depreciating assets, they are dragging back you financially. You won’t go forward if most of your income goes to those stupid bills. You need to get rid of them ASAP!

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Paying off debt is Investing

This concept may not be obvious to everyone but PAYING OFF DEBT IS INVESTING. For me, debt and investing are just two sides of the same coin. One side (investing) is to increase your wealth (with a given level of risk). Like you buy NZ Top 50 ETF from SmartShares, if the share price increase and they pay out a dividend, your wealth increased. On the other hand, the shares price may drop, and your wealth will decrease. So there is a risk of losing money with investing.

The other side of the coin (debt) will reduce your wealth. If you have $1000 credit card debt with 20% interest, your interest expense for the first month will $16.67. So your wealth reduced by -$16.67. Unlike investing, the debt will guarantee to reduce your wealth and drag you back financially. Therefore, reduce your debt will move you forward financially, guaranteed.

Whats the return and risk?

I will use a simplified sample to present the financial effect of paying off debt.

Assume you have $1000 in cash and $1000 credit card debt with 20% interest.  If you keep the $1000 in cash and don’t pay it off credit card debt, in one year, you will be $1000 x (1 + 20%) =  $1200 in debt. Financially you moved backwards by $200.

Now, you invest the $1000 cash in a 12 months term deposit with 3.25%. You still keep your $1000 credit card debt and not paying that off. In one year, your earn $1000 x 3.25% = $32.5 in interest from your term deposit. Take away $9.75 as tax; you will have $1022.75 in cash. On the other hand, your credit card debt still cost you $200 in interest. So financially, you moved backwards by $177.25.

Instead of invest that $1000 into a term deposit, you use that $1000 to pay off your credit card debt. Since the credit card debt is gone, it won’t occur interest. In one year, you will be in the same financial position.

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Look at all three scenarios, pay off credit card debt resulted in the best financial position. As you putting that $1000 cash to pay off your credit card debt, you are in fact getting 20% return on those $1000. Unlike other investment, those returns are Tax-free and guaranteed. If you need to get 20% after-tax return on investment, the pre-tax return will need to be 27.77%. That is an excellent return on investment. I am not saying you can’t get 27.77% return out there, but I am sure there is no investment (except KiwiSaver) can guarantee a 27.77% with no risk.

If we look that those high-interest-rate consumer debts, paying them off will be a great return for your money. Also, paying off consumer debt will reduce your financial risk and stress. You will be in a much better position when you negotiated mortgage term and resulted in better deals. That why paying off consumer debt is one of the top three investment options.

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What about Student Loan?

The student loan in New Zealand is interest-free as long as you are staying in the country. The payment only occurs when you have income. So you should just pay it off as you’ve got income. I would not be paying them off early unless you plan to leave the country for a long time.

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No. 2 – Join KiwiSaver

KiwiSaver is a voluntary, work-based savings initiative to help you with your long-term saving for retirement. It’s designed to be hassle-free, so it’s easy to maintain a regular savings pattern. Once you join KiwiSaver, at least 3% of your income will invest into a KiwiSaver fund. You can only access those fund until you use it to buy your first home or turn 65. What makes KiwiSaver to be a top investment option is because of employer contribution and member tax credit.

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Employer match

If you’re over 18 and is a member of KiwiSaver, when you make your KiwiSaver contribution, your employer also has to put money in. By law, the employer required to contribute at least 3% of your income. The employee can choose to contribute either 3%, 4% or 8% but employer only requires to match at 3%. Some employer may decide to match 4% or 8%.

It may seem you will be making 100% return on investment on your 3% contribution. However, IRD will take out tax from you employer contribution, so the actual return on your contribution is about 67%-89.5%. (You can find out why here)  It’s still an unbeatable risk-free guaranteed return.

Member Tax Credit

KiwiSaver Member Tax Credit is to help you save on your KiwiSaver. The government will make an annual contribution to your KiwiSaver fund (a.k.a Free money). The amount is $0.5 on every dollar up to $521.43. You will have to be 18 or above to receive the tax credit. This is a way of government help you save for your retirement and encourage you to join the plan. It cap at $521.43 so it will benefit for the most full-time employee but not favour mid to high-income earner.

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Return on Employee

If you are over 18, fully employed, annual income at $55,000 before and contribute at 3%. Your minimum return on your contribution will be like this.

Your annual contribution (3%): $1650

Employer contribution after tax: $1361.25

KiwiSaver Member Tax Credit: $521.43

The return on your investment: (1650 + 1361.25 + 521.43 – 1650) / 1650 = 114%

Return on Self-Employed

If you are self-employed, you won’t get the employer match, but you are still entitled to member tax credit as long as you make a minimum manual contribution for $1042.86

Your manual contribution: $1042.86

KiwiSaver Member Tax Credit: $521.43

The return on your investment: (1042.86+ 521.43 – 1042.86)/ 1042.86 = 50%

Those are only your base return; you are likely to make investment return on your KiwiSaver Fund as well.  Here is a couples data on a KiwiSaver fund with different income level. The KiwiSaver fund cost and return data are based on SuperLife 80.

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No. 3 – Reduce your Mortgage

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Mortgage payment can easily be the biggest expenses on most homeowners’ budget. Average first home buyer will spend $1500/month on the mortgage, and it will cost more if you have a mortgage in a major city. Imagine what you can do with that money if you don’t have a mortgage payment.

Return on Reducing Mortgage

Paying off have the same effect on paying off consumer debt. It will give you a tax-free and guaranteed return. The return is not as high as those consumer debts because the interest rate on the mortgage is lower at 4% – 6%. The equivalent pre-tax return is around 8.3%.

Reduce your Mortgage or Invest elsewhere

Some people may think 7-8% is not a very good return, and you can achieve that with other investment options without taking a lot of risks, like the share market. However, I still think paying off the mortgage on your own home is a better option because you are paying off an asset that will provide you with a place to live, offset the cost of renting in the future and the house will increase in value (in the long term for most cases).

If you can’t decide to reduce mortgage or invest elsewhere, ask yourself a simple question: 

If you fully owned your house today, will you borrow $500k on your mortgage-free house to invest in share market? Or you will use your income to invest in the stock market every month?

If you say you won’t borrow on your mortgage-free home (like me), then you should focus on reducing that mortgage now. I basically asked the same questions but put it in a different perspective. If you have the money to reduce the mortgage, but you put it into the share market, you are basically borrowing on your house to share market.

Saving Big on interest expense

Since the mortgage size is usually over $200K (over $500k in Auckland) and the payment terms are 20-30 years. You end up paying A LOT on interest expenses. Check out the chart below.

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For a 30 years term mortgage at 5% interest rate, you will end up paying 93% extra for interest payment. So what will happen if we increase our payment and shorten the mortgage by ten years?

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When we shorten the mortgage term by ten years (-33%), our monthly payment increased by 23%, total interest paid decreased by 37.3%! Only 36.9% of your payment went to interest.

Reducing mortgage may not give you a high percentage return, but due to the size of the mortgage, the saving you are likely to make is in the hundreds of thousands. I will have a series of blog posts in the coming month to show you how to be smart on your mortgage with different setup and tips.

Conclusion

  • The top 3 investment options in New Zealand are paying off consumer debt, join KiwiSaver and reducing your mortgage.
  • Paying off consumer debt is investing. The returns are in the range of 15% – 35%. You will be in a better financial position once you pay off your debt.
  • A KiwiSaver member can enjoy instant return from minimum 50% – 110% due to member tax credit and employer match. However, that money is locked-in until you purchase your first home or turn 65.
  • Paying off return about 7% – 8% on your dollar, not as high compared to other. However, due to the size of the mortgage and interest paid, you are likely to be saving hundreds of thousand of the dollar

Email thesmartandlazy@gmail.com or follow me on Twitter @thesmartandlazy if you have any questions.