Mortgages and the Eighth Wonder of the World

“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t, pays it!” Albert Einstein.

For the vast majority of people, owning a home comes with the burden of having a mortgage. Unfortunately, interest is the price that must be paid for enjoying the benefit of the home now before it has been fully paid for. Even in the recent high interest rate environment, this is largely an accepted cost despite the total amount repaid over time being far in excess of what was originally borrowed. For those who are in the fortunate position of having paid off their mortgage, and are about to tune out of this article, STOP! I may still be able to provide you with a useful tip to pass on to children, other family members or even friends who have or will have mortgages in the future, enabling them to reduce the impact of this cost over time.

Whether a mortgage is taken out directly with a bank, building society or through a broker, it is typically set up on a monthly repayment basis. This is made up of capital payments and interest payments. While a floating rate or tracker mortgage can be available, the vast majority of mortgages are on a fixed interest rate for a set number of years. With higher interest rates recently, there has been an increase in interest only mortgages, to reduce the overall costs for some. However, this is not a long term solution for most people to finance their main residence as they are likely to be without the means to repay the original capital in the future. For Buy-to-Lets (BTLs) this is a more common strategy, where selling the property to repay the capital in the future is a clearer strategy.

The most commonly known tip to reduce the impact of compound interest is, if affordability allows, to overpay on the mortgage. Most lenders allow up to 10% of the debt to be repaid each year without incurring any early redemption charges. Whether this is the best option really depends on the opportunity cost of that money and expected returns elsewhere. It is also a known return of the interest rate that is being paid (at least for the fixed period) whereas returns elsewhere, such as stock market returns, may be unknown and higher risk. So, while this is a ‘tip’ to definitely reduce the impact of compound interest over time, it is not necessarily the best use of capital if returns are expected to be higher elsewhere.

A less commonly known tip is to change the frequency of payments. I mentioned that mortgages are typically set up with monthly repayments and there are two main reasons for this. Firstly, people are usually paid monthly so before the temptation is there to fritter away the pay cheque, the monthly mortgage payment goes out - a tactic many individuals are comfortable with as a form of automatic discipline. The second reason is that, by default, mortgage payments are set up as a direct debit, and most banks only allow one per month per recipient. However, there is nothing stopping an individual from rearranging their repayments to a bimonthly or even weekly payment by standing order as banking institutions typically allow more frequent standing orders to be set up than direct debits. If, for instance, the mortgage debt was £1,000 per month, from the lender’s perspective you will have met your obligation whether you make one payment of £1,000 or four payments of £250. however, as long as you are paying in advance, the four payments of £250 is mathematically the better option. ‘Why?’ I hear you say? It is because interest accrues daily and so this daily compounding can have a significant effect over time. For simplicity, let us assume a month is four weeks. Then each month you will effectively have £250 only being charged 2 weeks’ compound interest and £250 being charged 3 weeks’ compound interest, rather than the full £1,000 being charged a full month’s compound interest.

I now hear you saying ‘that all sounds very well and good, but what does that mean in reality?’. Well, the difference this strategy makes will be individual to the amount being borrowed, the interest being paid and the term left to repay the debt. However, this strategy can reduce the overall interest being paid by more than 10% and / or reduce the time taken to repay the debt by a couple of years. Einstein was clearly on to something as that seems pretty wondrous given total monthly outgoing are the same!

It should be noted that this strategy relies on paying in advance and so any interest that would be earned on cash otherwise in the bank should be deducted from the overall benefit of paying weekly. However, as it is typical to hold a few months’ expenditure in a current account, and most current accounts do not pay any interest, particularly when rates come down. That means that this deduction could be nil.