Transcription
In this video, I'm going to tell you the truth about mortgage interest and show you how to pay off your mortgage early. With this knowledge, you can save a ton of money by reducing the amount of interest you will pay and finish paying off your mortgage years ahead of schedule.
I'm Gabrielle, a chartered professional accountant and founder of a tax-specialized accounting firm. I'm also on my journey to financial independence and want to share my learnings along the way so that we can achieve financial freedom together. One key aspect of financial freedom is paying off your mortgage, which is probably your biggest monthly expense. Can you imagine no longer having to make mortgage payments and owning your home outright? That will lift a huge weight off your shoulders for the rest of your life.
In this video, I'll start by quickly explaining how interest affects a mortgage and the shocking truth about how much interest we actually pay. Once we're on the same page, we will then calculate the mortgage interest and the three main strategies to pay off your mortgage faster, ultimately fast-tracking your path to financial freedom. So, let's get right into it.
How interest affects a mortgage and the shocking truth. When you first get a mortgage, you're given a monthly payment schedule that you'll need to follow for the next 5 years until your mortgage renews. Most people focus on whether they can afford the monthly payment, but it's crucial to consider how much of that payment is actually going towards interest over the lifetime of the mortgage. Banks often don't make the effort to be transparent about this. It's in your best interest to understand this critical factor. By doing so, you can save thousands of dollars on interest payments and even shave years off the time it takes to fully pay off your mortgage.
In a nutshell, the monthly mortgage payment has two parts: the principal and the interest. The principal is the amount that you borrow to buy your home, which you would need to repay over time. And the interest is what the bank charges you for loaning you the principal. This interest rate depends on various factors like the economy, the prime rate at the time, and bank fees. Obviously, the higher the interest rate, the higher the payments are going to be, and more interest you will pay over the life of the mortgage. It's essential to understand how much of your monthly payment is going towards the principal versus the interest, especially in today's market where interest rates are the highest that we've seen in decades.
Another key factor is the amortization period, which basically means how long will it take to pay off your mortgage. In Canada, the default is 25 years, and in the US, it's 30 years. A longer amortization period means lower monthly payments, making it more affordable, but ultimately means higher total interest payments over time. To hit this home, let's go over an example. Let's say that you borrowed $400,000 on a 30-year mortgage with a current interest rate of 5%. Assuming the interest rates stay the same and that you don't really use strategies to pay it off sooner, you'll make total payments of around $773,000 over the life of the loan. Out of this $400,000, obviously, goes towards repaying the principal, but a staggering $373,000 will be paid as interest alone. That's almost equivalent to the size of the principal that you just paid off. You could have actually bought another home with this amount. Let me know if you found this shocking in the comments down below.
Welcome to the tutorial portion of this video, where I'll be going through a detailed calculation of the mortgage interest, as well as go over three main strategies on how to pay off your mortgage early. So, let's get started right away. Just some housekeeping here. As you can see, there are cells in green and there are cells in gray. The cells in green are for you to update based on your particular situation. I've inputted some of the numbers that we are already familiar with that we had already gone over. So, in this particular case, the mortgage amount is $400,000 with an annual interest rate of 5%. Even just to keep things super simple, the amortization period is 30 years. So, as mentioned, this means it will take 30 years for you to pay off the mortgage of $400,000. And based on those factors, the calculated fixed monthly payment is $2,147.
I know that this monthly mortgage amount may have changed for some of you on variable interest rate mortgages, just because of the rapid interest rate increases in the past couple of months, which may have resulted in you reaching the threshold amount, which means that your monthly payments are not even covering the interest payments alone. So, many of you guys may have experienced higher monthly payments, as well as higher amortization periods as well. But in this case, let's say based on the above, this is your fixed monthly payment. If this is not the case, you're more than welcome to go in and change to your actual mortgage amount, and then the rest of the calculations will be updated. But you can see that this is based on a formula.
So, based on these assumptions, we could go to the base case and see what that results in. And as mentioned, the total principal is paid off during the course of 30 years, but you also need to pay interest of $373,000, resulting in total payments of $773,000. So, as you can see, this is a shockingly huge amount where you are basically paying the equivalent of the principal over the course of a 30-year amortization period. With this new information, you might want to prioritize paying off your mortgage as fast as possible so that you can save on not only rate but also be debt-free of your mortgage sooner than 30 years.
So, I'll be sharing with you three main strategies. In the summary tab, there are three main scenarios that we'll go over in detail. The first scenario is the lump sum payment, where you have saved up a significant amount and you are considering in applying that towards your mortgage. Scenario two is making extra monthly payments, whatever extra savings you have on a monthly basis. And scenario three over here is making bi-weekly payments, which means that you'll be taking the monthly amount and dividing it into two payments and making a payment every two weeks. And what this allows you to do is basically make an extra payment, so a 13th payment every single year, which will fast-track you paying off your mortgage. So, those are the three scenarios.
And I have put in some assumptions here. This can totally vary based on what you have. But the assumptions that we will go with is scenario one, where you have a lump sum payment of $220,000. The second one is making extra monthly payments of $200. And then obviously, scenario three is just making bi-weekly payments, and we'll see how that compares. So, let's go over scenario one in a little bit more detail. If you have a $400,000 mortgage, but you are able to put down, let's say, $20,000, that brings your mortgage amount down to $380,000. But given that you have the same fixed monthly payment as $400,000 on mortgage, it means more is going towards principal every single month. So, here you can see right away that principal starts at $563 versus principal here in the base case of $480. And with that, you're able to pay off your mortgage a lot sooner. And you can see what that results in the summary page, where you will be able to pay off your mortgage in 26.8 years' time compared to the typical 30 years that you first signed up the mortgage with. And because you paid off your mortgage with the lump sum amount and you're paying off your principal faster, your interest is also reduced to $310,000 compared to $373,000. And so with that, you're saving, we could just do a quick calculation here, $62,500.
Now, keep in mind, with lump sum payments, there are limitations with the bank. For example, certain banks allow you to only prepay a maximum of 20% of the mortgage every single year. So, let's say 20% of $400,000 would be $80,000. So, that is the maximum amount that you're able to prepay every single year, once a year. And with a $20,000 lump sum, it's considerably under the limit. And if you do end up paying more than $80,000, you may be subject to some penalty. So, make sure that you check with the bank before making a lump sum payment.
Now, with scenario two, you can see that everything else stays the same. The mortgage amount stays the same, except the calculated fixed monthly payment is higher by $200 because you're contributing an extra $200 towards your mortgage. So, you can see that for principal payments, you are making higher contributions compared to the base case. So, the first payment is $200 higher. As you can see, your interest payments also decrease over time compared to the base case. And with that, you can see that in the summary, because you're making those extra payments compared to the lump sum payment of $20,000, you're actually able to pay off the mortgage even faster, 24.8 years. And of course, we can also expect to see lower interest of $298,000, which you can see here summarized. And with that, you can see that you are saving significantly in interest payments of the difference of $774,000.
Now, keep in mind, you know, prepaying your mortgage, there it might come with some limitations depending on what bank you are with. The current bank that I'm with, they allow you to pay up to the monthly amount, so let's say here $2,147 towards your principal every single month without penalty. So, clearly here $200 is under the monthly amount, so you are good with paying off your mortgage as soon as possible under this limitation. And if you do decide to make these monthly payments, make sure that you set it up properly and that you're making these payments towards your principal only, and that it is not being split between principal and interest, because that way you're not paying your principal off sooner because you're also making a portion of the payments towards interest as well.
Now, moving on to scenario three, which is making bi-weekly payments. And by doing this, you're essentially making an extra payment every single year. And if we look at the detailed calculations, you can see some of the details here have been adjusted based on the period, which is 26 weeks instead of 12 months in a year. So, there is a total of 780 periods where you need to make these payments. And the payment per period is $174, which is basically half of this amount here. With this calculation, you have to take into consideration every payment is on a bi-weekly basis. So, if you want to see the monthly effect, then you would have to add up two payments. So, here you can see that the principal payment is $69 compared to the base case of $480. And then also the interest is $1,537 compared to interest of $1,666 in our base case. So, you are making more contributions to your principal. And with that, you are also expected to pay off your mortgage faster. And in our summary, you can see that it will take you 25.2 years to pay off your mortgage compared to 30 years. And then just going back to the total interest amount that is being paid over the course of the mortgage, it will be $34,000 compared to our original base case mortgage interest of $373,000. So, the savings there, we can calculate as $68,500.
So, now can you imagine what you can do with this extra interest savings of $63,000 or $74,000 or even $69,000? Like, these are big amounts that you can save over the course of the mortgage just by implementing one of these strategies. And even better is if you could do a combination of all three of, you know, saving up whatever you can, like your tax refund, and making that payment towards your mortgage, I'm coming up with additional savings every single month, and then paying your mortgage faster, as well as maybe implementing one more payment every single year by doing bi-weekly instead of monthly payments.
Now, with this calculation, you can see that the best-case scenario, there's even a formula that calculates the best option. And in this particular case, it'll be scenario two of making $200 extra payment every single month, which will allow you to shave off more than 5 years and also help you save $74,000 in interest. Now, keep in mind that this conclusion will change depending on what your assumptions are. Let's say that you have a monthly payment of $100, or you have a lump sum amount of $25,000. In that case, the assumption changes where the $25,000 is a little bit more advantageous. Or let's say you only have $5,000 from a tax refund, but you're able to, you know, come up with more extra savings every single month of $300. In this case, the $300 is more advantageous. So, something that I do want to emphasize is, you know, depending on your particular assumption with all of the cells in green, including the amount of mortgage, the mortgage rate, amortization, all of that, your conclusion may differ. And I do want to put that out there. And if you are interested in this particular template, then make sure to check out the description box for more details.
To bring everything together, what do all these strategies have in common? They are all different ways to make extra payments towards the principal of the mortgage. That way, you pay less interest since you have less borrowed money, and you can pay off your mortgage faster since more money is being allocated towards paying off your principal each month with the same monthly payment.
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