How Much Are You Really Borrowing?
How much are you paying back?
When considering a mortgage do you consider all of the right questions, for example do you consider which bank is best because of their reputation or do you instead look solely at the interest rate tables, do you look at the ability to switch mortgage provider or do you look at how long they can guarantee a given mortgage rate? These are of course all important questions and ones that should be given due consideration when choosing a mortgage provider – but there are more important questions.
Most of us consider a mortgage to be one of life necessary evils, after all, it’s not nice to be in debt to the tune of the house price right. Well, there’s actually one question that most people ignore if you’re borrowing $100,000.00 how much are you actually paying back?
The reason that most people ignore this fact when they consider choosing a mortgage, refinancing or embarking on any other kind of equity refinance is that on paper you are borrowing a given sum (100 K in this case).
You are borrowing a few thousand now but that is not the amount that you’ll be paying back.
This may seem like a bit of a nonsense statement but lets analyse it in a little detail.
We initially borrow $100,000
The interest rate is 4.25% - per year
Our repayments are the interest + 4%
We take the mortgage/refinance over 25 years.
So our yearly figures are as follows:
Interest = $100,000 / 100 * 4.25 = $4,250
Amortisation (paying back) =$100,000 / 100 * 4 = $4,000
Total to pay back this year $8,250
So now in year two we only owe $96,000, so it looks like this:
Interest = $96,000 / 100 * 4.25 = $4,080
Amortisation (paying back) =$100,000 / 100 * 1 = $4,000
Total to pay back this year $8,080
So as you can see, there’s less interest to pay because we’re clearing the initial balance, but still we’re paying 4.25% per year, so if we borrowed $100,000 to start with how much are we actually paying back in the end?
We’re actually paying back $151,000 in the end, that’s right, the interest on the mortgage is $51,000 – doesn’t seem such a good rate any more does it. But what if you decide to pay back over a longer period, that might help right? Wrong, if you double the term to 50 years (so paying back 2% per year), then the interest effectively doubles the amount of your mortgage to just over $200,000.
Now perhaps when people discuss getting the best rate for the mortgage and seem to be messing about for a few points difference you can see why, perhaps now you can also understand that it is better to take a mortgage over the shortest possible time frame – it does mean that you’ll need to amortise faster but it also means that you’ll potentially save yourself thousands in interest payments.
If you are not financially in a position to really negotiate initially then perhaps one of the most important questions you should be asking is whether or not there is an early repayment option – you might have enough money to pay it of early but what’s the point if the bank will still charge you the same amount of interest?