Understand the Math of Mortgage

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.

Where to invest your money in New Zealand (Part 2)

At the last post, I made a simple graph to explain where to invest your money. Now let’s break it down in more detail

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Within 1 year – Cash in Savings

For such a short terms, your best bet will be keeping your money in a savings account. Most banks offer serious saver or notice saver accounts with interest around 2.25 – 2.75%. I know it’s not a good return but its better than nothing. You may also consider a 6 months to 1-year term deposit for higher interest (3 – 3.5%). However, if you need to get your money out early, you may lose the interest and pay a break fee.

Recommended products: ASB Saver Plus, ANZ Serious Saver, BNZ Rapid Save, Westpac Online Bonus Saver, Kiwi Bank Notice Saver, RaboDirect Premium Saver and Notice Saver.

2 to 3 years – Cash in Term Deposit

You still want to play it safe so you should keep the money in cash. In this time frame, you can use a term deposit as they have a higher return of interest, around 3.5 – 4%. As mentioned previously, watch out of the penalties for early termination.

Recommended products: Term Deposit for all major bank.

3 to 5 years – Income Asset (Bond and Dividend Stocks)

If your money can stay in the market for 3-5 years, income assets become a feasible opinion. BBonds are not as stable as term deposit return, but they do offer the potential to earn a higher yield. I would suggest investing in a Bond ETF or a Bond Fund over buying individual bonds via a stock broker for small investors due to the cost of trade. Bond ETFs and Funds  invested in multiple corporate and government bonds, which should reduce the risk

If you are willing to dip your toes in the share market, you can buy some dividend shares at this stage. Dividend shares are usually associated with established and mature companies on the board that pays out dividends constantly. Don’t expect those companies to have rapid growth but they usually pay out dividends every quarter. The volatility of those shares is smaller compared to other shares on the market. Spark, Auckland Airport, and power companies are considered dividend stock in New Zealand.

Recommended products: NZ Bond ETF, NZ Dividend ETF, NZ Bonds Fund, Global bonds ETF, Overseas Bonds Fund.

5 to 7 years – Shares, Property, and Bond

At this stage, growth assets will play an important part in your investments. Growth assets are shares, properties, and managed funds. The reason we shouldn’t touch growth assets until this stage is because of the volatility of the return. Year-to-year return can be ranged from -80% to +80% , but over longer periods it usually goes up. Take a look at the graph below. It shows the NZ stock market’s return in 2 years from April 2007 to April 2009.

If you invested in the stock market in April 2007 and planned to exit the market in April 2009, you would have lost about 35% of your investment.

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On the other hand, if you had stayed in the market for 7 years, you would have gained 24% on your investment.

The same principle applies to property investment. The House Price index from 2000 to 2016 shows New Zealand property prices are trending up in the long term. You can see there was a dip during the 2008 GFC and the price recovered within a few years.

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Therefore, in this timeframe, you should invest more and more into growth assets and the ratio of Bond and Dividend stocks should decrease.

Recommended product

30-80% of Growth Asset: NZ Top 50 ETF, S&P 500 ETF, Total World ETF,  Property Fund, Oversea Shares Fund, Australian Shares Fund.

70-20% of Bond and Dividend shares.

 7 years+ Mostly Growth Asset 

At this point, I recommend invest 90% of your investments in growth assets and expect a long-term positive return on share and property. You may wonder why the income asset portion goes down to 10%. Although income assets are considered a safer investment, but they cannot match the high return of growth assets. Having a small amount of income assets in your investment will help offset potential downturns in your growth assets. Income assets don’t crash like growth asset, it will act as a cushion to soften any drops in the market.

Some people think if you are young and you can handle a market crash, you should have 100% growth assets as your investment. Whilst I agree with this point of view, it basically comes down to risk tolerance and personal preference.

Recommended product

90-100% of Growth Asset: NZ Top 50 ETF, S&P 500 ETF, Total World ETF,  Property Fund, Oversea Shares Fund, Australian Shares Fund.

10-0% of Bond and Dividend shares.

What’s Next?

So this is the guide that I used to decide where to invest my money based on how long I was going to invest. In the next post, I will talk about risk tolerance adjustment and how KiwiSaver funds fit into this graph.

The timeline and investment ratio used in the graph are based on my own studies and conventional wisdom. Investment suggestions are based on neutral risk tolerance. Investment products listed are based on popularity, ease of access in New Zealand and a bit of personal preference.

Just a reminder, this graph is for GENERAL ADVICE ONLY. Your own situation may be different. Please thoroughly research everything you read here and seek professional advice if you need to.

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

A Simple Graph that explains… where to invest your money

The No. 1 personal finance question being asked online is “I have $XXX in saving, where should I put it?” or “What should I do with my term deposit?”. People who are unfamiliar with personal finance usually have no idea where to investment their money except term deposit and property (Oh, the old Kiwi dream). While property seems out of reach and interest rate on term deposit are hitting all time low, Kiwis are looking for another way to invest for their future.

Before you jumping into the world of investing…

You should put your money to invest after you pay off your consumer/personal debt, join KiwiSaver, and have an emergency fund. I believe you are not in the position of investing if you still haven’t got your financial basic sorted out.

The most important question

The first thing you’ll need to work out is How long can you leave the money in the investment? or how long before you will need to use that money?

If you are saving for a new car in 3 years, then 3 years is your answer. If you are saving for retirement and you are 30, 10+ years will be your answer.

Make sure you have money set aside for emergency before you invest. You don’t want to be in a situation where you plan to invest in the stock market for 8 years, some emergency happen in year 2 and you are forced to sell your investment at a loss.

Once you’ve worked out the time, apply that to the graph below.

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Example

Let’s say if you plan to invest for 6 years, according to the graph, you may want to consider invest 60% of that money into growth assets such as stock, property, ETF, and index fund, while the other 40% investment into Bond or Dividend stocks.

If you invest for your retirement in 20 years, you may want to have a portfolio with 5-10% bond and the rest with stock.

On the other hand, if you wish to use the money to buy a car in 2 years. It’s best to put it in a term deposit.

Break down your plan

You may have multiple plans for your money, such as $3000 for travel next year, $12000 for a new car in 30 months, and $20000 for the first home in 8 years.

You need to apply those plan individually to the graph.

$3000 travel fund in saving account

$12000 car fund in term deposit

$20000 in a 10:90 mix portfolio while you keep adding more into the investment every month.

What’s next?

I will explain the basic idea of this graph, the mix of investment in this post and how to apply risk tolerance in the next post.

The timeline and investment ratio on the graph are based on my own study and conventional wisdom. Investment suggestion is based on neutral risk tolerance. Investment product listed on the graph are based on popularity, ease of access in New Zealand and a bit of personal preference.

Just a reminder, this graph is for GENERAL ADVISE ONLY. Your own situation may be different. Please thoroughly research everything you read here and seek professional advice if you need to.

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

My First mortgage as a noob

I was sorting my paperwork and saw my old mortgage paper. I was such a noob back then and made a lot of mistakes when I set up that mortgage.

Hunting for our First home

When I and my wife start hunting for house couple years back, we’ve done the first timer mistake by walking into my friendly local bank which I’ve been banking with for 10+ years, ask about home mortgage and got introduced to a personal banker. Had a 30 mins meeting where the banker took our account statement and worked out our income, expense, and deposit. We walk away with a 600K loan pre-approval.

So, we went on to house-hunting and luckily got a house at auction (passed-in then negotiate). We took the purchase agreement to went to the bank again. This time stayed there for an hour. Got a 500K fixed 2-year at the advertised rate home loan, pay monthly plus a life insurance for both of us, house and content insurance. I was so proud of myself because I also got a $1000 cash back and used that to pay the lawyer. The mortgage payment was about $2400/month plus $180 for the insurance. I remember when I walk out of that bank I felt a sense of accomplishment. I knocked down home ownership, mortgage, life, content, and house insurance on the same day.

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The list of stupid things that we’ve done.

Now I look back at the mortgage statement, I was such a NOOB!!!! I’ve made so many first timer mistakes!!!

  1. I walked into a bank and get the personal banker to do my mortgage.
  2. I took the advertised rate.
  3. I 100% fixed my mortgage.
  4. I pay my mortgage based on what the bank said.
  5. I pay monthly.
  6. I accepted the $1000 cash back.
  7. I did not get a friend to do a referral despite heaps of my friends are with that Bank.
  8. I buy insurance from the bank.
  9. I did not ask for fee-free credit card
  10. About 18 months into that fixed term, some news headline saying interest rate is going up. I considered very hard to break the contract and refinance.

The ONLY thing we did right was the downpayment. At that time, you can get a home mortgage with just 5% deposit and lots of people did that. We decided to put over 20% as deposit since we saved up some money already.

At that time we didn’t know much about mortgage….actually, we don’t know much about money, personal finance, saving and spending at all. We were stuck with this deal for 2 years and within that time, we had a money crisis that forced me to educate myself about money. I read books from the library, research online,  builds home loan model in excel and ran a bunch of analysis. Now I have a nice setup on a home mortgage with every dollar working to reduced the interest expense.

I am interested to know any of you made those mistake when you first took on a mortgage?

Also if you don’t know what I’ve done wrong or you actually doing the same thing, check out this blog post and I will explain what I’ve done wrong.

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