The “Miracle” of Compound Interest

Ok, so it’s not really a miracle. That just happens to be what the financial specialists like to call it. However, compound interest plays an important part of how you manage your mortgage, so this month we are going to focus on how this concepts plays into your long term plan.

Compound interest is interest added to the principal of a deposit or loan so that the added interest also earns interest from then on. This addition of interest to the principal is called compounding. A bank account, for example, may have its interest compounded every year: in this case, an account with $1000 initial principal and 20% interest per year would have a balance of $1200 at the end of the first year, $1440 at the end of the second year, $1728 at the end of the third year, and so on.

Your financial future depends on this concept. Unless you are someone that thinks the government will take care of you into old age, you need to save money. You need to have money for living expenses, you need to have insurances for the unexpected, you need to have funds set aside for emergencies, you need to have money put away for when you reach the point where you are no longer physically able to work. If you save money and that money is compounding interest you obviously have less to save to reach the point where you have that comfort level. If that passive income then earns more money for you by compounding additional interest you are making your money work for you.

Why does this affect me in the mortgage world? Most people I deal with for mortgages are focused on their mortgage rate and how to eradicate that mortgage as quickly as possible. People see their Truth in Lending disclosure and the ridiculous amount of interest they will pay over the course of the loan and all of their focus shifts on avoiding that. For example, if you are 25 years old and you take out a $200,000 loan you will pay $143,739 over the course of 30 years. I could write a whole different newsletter about why paying all of that interest still outweighs renting but the point I want to drive home today is that if your focus is on saving money instead of earning more you will not be able to outpace spending. Also, every extra payment you make to the mortgage lender gives them the leverage advantage until the day you pay off that mortgage in full.   If you have been paying extra money towards principal and then get hurt at work, fired, laid off, etc. how will you pay your mortgage? If you are not insured properly and don’t have enough liquidity you may end up going through the foreclosure process and all of that money that you put into that house will no longer be yours. After all, which house do you think a lender will be more patient on during the foreclosure process? The one with 10k in equity or the one with 100k?

Does this mean that paying extra on your mortgage is a bad idea? Absolutely not. What it means is that you have to prioritize your plan. Do you have savings? Do you have an emergency fund? Do you have disability insurance? Do you have life insurance? Are you max funding your retirement accounts? If you said no to any of those questions your focus should not be on paying additional to the principal on your mortgage. If your answer was no to any of those questions you may need to work with a financial professional to help get that part of your plan on track. If that is the case please let me know. I work with several financial planners and would be glad to match you up with someone.

Thank you for taking the time to read this month’s newsletter. If you have any questions or suggestions for future topics feel free to reach out to me at brian@teamhuntonmortgage.com.

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