Owning your own home, mortgage free by the time you retire is probably the minimum prerequisite for anyone who wants to live comfortably in their golden years. So, what I’m about to suggest may come as a shock to you:
Paying off the principal on your loan, over the lifetime of the loan, isn’t necessarily the best way to pay off your mortgage by retirement.
Surely such a statement is sacrilege? For as long as I can remember, the importance of paying off the mortgage before we retire has been drummed into us, as a mantra. But my suggestion isn’t challenging that idea – just the way in which we achieve it.
Consider the way that a mortgage usually works. You borrow a sum from the bank, which is secured against your home, then, over the lifetime of the mortgage you repay the original sum borrowed and also pay interest on that sum. In most cases that mortgage will be structured as something called a "table mortgage", which simply means that the bank factors in the reducing cost of interest as you pay off more principal and calculates it as one consistent payment, per month, throughout the life of your mortgage.
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But what if you didn’t repay the original loan, only the interest? How could this work? Well it all comes down to capital growth and the history of cycles in the New Zealand property market.
Consider this: when my mum and dad built their own home in Napier in 1970 it cost them $30,000. They didn’t actually need all of that as they paid a deposit of $4,000 toward the home, but for the purposes of this exercise let’s assume that they borrowed the whole sum and that the house was worth the same amount: $30,000.
In 1980, ten years later, their home was worth pretty much what they paid for it in 1970, but in each of the following four decades the house more than doubled in value and is currently worth around $525,000. Mum sold that house a few years ago but these numbers mean that, instead of struggling away to pay off the principal back in the 70s and 80s (a lot of money at the time), she could have simply paid off the original $30,000 loan sum from the proceeds when she sold the house. A small amount, relative to what the house actually sold for.
The story gets even more compelling for property investors. If you purchase three or more properties over your lifetime and hang on to them, then chances are that the resale of one will pay off the mortgage on the others, even if you only ever pay interest on the loans against all three.
The longer you own property the more this strategy works in your favour, and the reality is that most people probably wouldn’t wait until retirement until making that final lump sum payment. As in my mum's case, the original mortgage sum had become so small that she could probably have repaid it earlier if she had chosen to do so.
This strategy isn’t for everyone, of course. For starters, it requires a belief in the concept of "property cycles" and a degree of confidence that these will continue into the future. For others, the change in mindset from "paying off the mortgage" to "paying only the interest" is simply too much to get our head around and seems more like wizardry than economics.
Some will also point out that you would actually end up paying more, in nominal terms, if you only paid interest and repaid the original sum borrowed, as a lump sum at the end of the same period you’d have paid off a traditional mortgage. This is true. The $30,000 my mum and dad borrowed would have cost them around $58,000 over 30 years at 5 per cent - but $75,000 if they only paid interest throughout the life of the loan and repaid the principal at the end. But this is overwhelmingly offset by the effect of inflation and in real terms they’d have ended up paying dramatically less.
Of course, it isn’t a given that a bank would allow you go interest only for a prolonged period, if at all. Generally, bank policy is to only allow mortgages to be interest only for up to five years – and some banks will allow interest only for investors but frown upon it as a strategy for owner occupiers.
For all of these reasons going interest-only isn’t right for everyone, but for those keen to save some money, or to divert it to other purposes, it’s well worth a second look.
- Ashley Church is the former CEO of the Property Institute of New Zealand and now writes on behalf of OneRoof.co.nz. Email him at [email protected]
