Let's clear up some mystery on this topic
I first learned about compounding interest from my 5th form Economics teacher and it seemed to make sense if you were investing money. It didn't make a lot of sense if you were borrowing money but in this blog I'm going to show how you can turn the tables and use savings on interest to save you more on interest which, if you're as nerdy about saving money on your home loan as I am, will make you about as happy as this guy above!
I'll explain the details of how this works below but if you'd like us to give you a personalized report on how you can improve your loan structure, save money and repay your home loan faster simply click this link for our "My Best Home Loan" tool, complete a few details and we'll send you a report on suggested improvements within 24 hours.
Compound interest is simply described as "earning interest, on interest that you've already earned". So if you have $100 invested and earn interest of 10% then next year you will earn interest on $110 instead of your initial $100 investment. Makes sense for an investment but how does it apply to your mortgage?
Well compound interest does occur on most home loans, interest is charged daily on the balance owing so you pay interest on yesterday's balance, plus yesterday's interest. But don't worry as 95% of people have a "table" loan (which is the standard one with a term over x amount of years and a simple weekly/fortnightly/monthly payment) and this compounding interest is factored in to your repayment over that term. How to make it your friend?
There is a really simple way that you can make this your friend by having a portion of your loan on a floating or revolving loan. We would advocate for most people to have most of their lending fixed, to provide certainty of their repayments, cost and to secure the cheapest interest rates as these are generally for fixed rates. However a portion on floating/revolving will save you far more in the long run if you can make even small extra payments.
Let's say you have a total home loan of $310,000. We'll fix $300K and leave $10K in a revolving credit. We'll explain more about Revolving Credit and how to use it well in a future blog but for now let's just view this as an account with an overdraft, but that overdraft is charged at the home loan floating rate so is relatively cheap.The interest on the $10K is going to cost you about $46/mth. With interest calculated daily on the balance as mentioned above.
If you paid $1000 off the $10K then you would only pay interest on $9K next month. Which would cost you only about $41/mth. Meaning that if you paid $46 for this month you'd be paying an extra $5 off the balance and the cycle would continue downwards with any extra funds you paid. This is essentially compound interest in reverse, the more you pay off, the lest interest you pay and the quicker you pay your home loan balance off.
If you'd like an explanation on how a structure like this would work well for you or just how you could save money and pay your home loan off faster feel free to email us directly and we can give you some specific advice. Here is a link to email me.
Hopefully you can put this to use to save money and we'll have some more helpful tips up soon.
Adam and the team at My Mortgage