Paying off more in your first year has the biggest impact
It might seem strange, but in the first few years of your home loan, you usually just pay off interest and barely touch the amount that you borrowed in the first place. This means that the interest on your loan won’t start to reduce for quite some time if you only make the minimum repayments.
If you can tweak your budget to pay just a little bit more each month, or each fortnight, you might be surprised at what a difference it can make.
Example: paying more than the minimum
On a loan of $400,000, by paying an extra $50 each month, you could save around $36,000 on your total interest – and pay your loan off 1 year and 9 months earlier than expected.
The first year of your loan is the most expensive, by which I mean that it is the year in which you pay the most interest while paying the least off the loan. On a 30-year $300,000 loan at 7%, you would be paying $1,996 monthly repayments. That means that you pay $23,952 in the first year, but you would have only reduced your loan by $3,047.43. You have spent over $20,900 just on interest.
However, the positive to this is that the first year is the time when you can make the biggest impact on the future cost of your loan. In the first year, you can pay your loan off twice as fast with a relatively small increase in your repayment. If you increased your repayment by $253 per month for just the first year, at the end of that year, you will have paid off $6,182.71.
You have more than doubled the rate you are paying your loan off, but you didn’t need to double your repayments. Not only that, but by having paid that extra $3,036 in the first year ($253 x 12 repayments), you will now save a total of $19,974.80 in interest over the remaining term of your loan. That is a huge amount to save, and it only took a moderate adjustment to the regular payments.
The Most Effective Repayment Strategies
Of course, we all know that increasing your repayments will save you interest, but the key point is that you are much better off doing it at the start of the loan than later on. If you waited until the 10th year of the loan to make these higher repayments, you would only save $9,443.21 in interest.
Do you buy a takeaway coffee every day on the way to work? By saving that $4 per day, and paying the savings off your loan now, you could save about $55,000 on your total interest, and pay your loan off about 2 years and 8 months early.
Try making a list of all the small things you spend money on daily or weekly, and see if there is anything you could happily do without. Grab a calculator and multiply the item by 52 weeks, and then 25 to 30 years. You might be surprised what you find!
The takeaway here is that extra repayments at the start of your loan are much more effective than extra repayments later on.
That’s why I often say that you should view your home loan like a savings account, but with a guaranteed tax-free rate of return that is much higher than any bank’s saving account will give you.