The Power of Mortgage Pay Down

Mortgage Pay Down

In this article I want to go over the power of the mortgage pay down. We've all heard of the importance of a mortgage, but today I want to explain why it's so powerful. Here are a couple quotes to help get you thinking about the power of a mortgage:

What you owe today, you will own in 30 years. What you owe today, you will own in 30 years.

As you pay down that mortgage, you will own what you owe today.

Another one:

Today's debt will be tomorrow's net worth. Today's debt will be tomorrow's net worth.

Debt can be a good thing if you pay it off in tomorrow's dollars.

So when you think about taking on debt and think about taking on a mortgage, typically we think in terms of 30 years for the single family house or townhouse, residential real estate. In this article we will look at the power of a 30 year mortgage.

In order to look at just the pure power of the mortgage itself, I'm not going to have any consideration in this example for cash flow, for appreciation, or for the impact of inflation, either positively or negatively.

I want to strip everything away except for the terms of the mortgage itself, so you can see the impact and the power of paying down a mortgage.

Let's assume a property market value, your townhouse or single family house, is worth $200,000. Let’s assume that you're going to buy that house and you put down 20% at closing or $40,000. You could put down more, you could put down less, and it would change what happens here, but this is a good rule of thumb. This is a clean example so you can get a sense of the power of a mortgage all by itself.

So in this scenario, your loan amount is going to be $160,000, the principal and interest that we're going to have on this loan is based on an assumed rate of 5%, and we're just assuming 5% - it could be less, it could be more.

It's going to be a 30 year loan, fully amortized. And what that means is each month you make a payment, each year you pay your loan, make your payments - it is going to continue that way for 30 years; it's fixed. There's no balloon payment; there's no adjustable rate. It's fixed for the 30 years. And in this scenario, that means your monthly payment would be $858.91.

Now, let's look at the return on that down payment over the course of 30 years. Remember your down payment is $40,000 and we're not going to assume any appreciation, even over the entire 30 years. Of course, that's ridiculous. But at the end of 30 years, for the sake of discussion here, we're going to assume that the property you bought for $200,000 - 30 years later is now still only worth $200,000.

What will happen to your return if that's the case? Will it be a failed investment?

Well, you have a starting equity of $40,000 and then an ending equity of $200,000, so what is your increase? What is your equity position gain? Your increase is $160,000 of equity, so what's the power here of the mortgage pay down?

Here's how you calculate it. You take the $160,000 which is your gain and you divide by 30 years and that tells you that for every year during this 30 year term, you have a $5,333 profit as a return on that down payment.

The return on investment calculation is 5,333 divided by 40,000 -which was your down payment, and that gives you a 0.133 return or a 13% return per year, every year for 30 years.

Now, just let that sink in for a minute...

Once this mortgage has been paid down at the end of 30 years, you will have an increase in your equity position of $160,000. Your total gain over the period is 160k.

That would mean for 30 years, every year, you are gaining $5,333 of equity or profit or return on this original $40,000 investment. Which means it's a 13% return every year - if you look backward from the end of the term.

What investment can give you a 13% return year after year for 30 years straight? And the question you might be asking yourself is, how in the world have I missed this? How could I not see this power of the mortgage. Well, one of the reasons we miss it is we miss the big picture. We look at the mortgage on a year by year basis moving from year 1 to year 30. To see the power, you need to look from year 30 back to year 1!

The early years of a mortgage tend to trip us up because we start making these payments and we're looking at the pay down on the loan and we say, “I haven't done anything. I've hardly paid anything toward paying down this mortgage.” It’s because the early years of the mortgage are weighted heavily toward the interest and the equity build up is smaller and slower.

For example, after 10 years of mortgage payments on our scenario of 30 years and a $160,000 loan, how much have we paid down? After 10 years, that's 33% of the time of the loan, one third of the time of the loan, you still owe $130,000. In other words, only $30,000 of the principal has been paid down, or 18% of the principal has been paid down after 33% of the time. So you look at that and you say, “Hey, I've been doing this for 10 years and I've only paid down 18% of it!” That's what trips us up.

But don't let that fool you. You need to take the whole period into consideration. We look at the mortgage on a year by year basis moving from year 1 to year 30. To see the power, you need to look from year 30 back to year 1! You need to see the total period of the the mortgage and it’s complete pay down to see it’s real power and it’s true ROI.

Do you know what “mortgage” means? The word literally means to put to death. So when you're paying down a mortgage, you are year-by-year putting to death the debt. The debt that you owe now will be your net worth in the future.

The total return worked backwards yields the true yearly return. So once the 30 years are paid off, then you look back and calculate. Your overall return would have been a 13% return for 30 straight years. Friends, that is the power of a mortgage pay down.