By paying just $1 a day extra on your mortgage, you can hack the banking system and cut the time to repay your home loan from 20 years to just five years.
Sounds too good to be true? Of course it is.
But that hasn't stopped someone "good at finance" from claiming this in a TikTok video that's garnered millions of views and spurred dozens of other "finfluencers" to amplify its claims.
According to the video: "The reason banks want you to pay interest monthly is because they rely on a thing called compound interest.But if you pay the bank $1 every day you "will pay a big fat zero in interest".
The video goes on to say "mortgage" is a Latin word, and the reason "they" stopped teaching Latin in schools is because "they" don't want people understanding how the banking system works.
If this sounds like a conspiracy theory, it's because it is. Like all conspiracy theories, this one is a falsehood built on a few grains of truth, taking advantage of people's ignorance about complicated matters.
So let's separate the facts from the fiction.
What is compound interest?
Compound interest, in a nutshell, is interest on interest.
Say you put $1,000 in a savings account that pays 10 per centinterest. After the first year, you would have $1,100 ($1,000 + $100 in interest). At the end of the second year you will have $1,210 ($1,100 + $110 in interest). At the end of the third year you will have $1,331 (1,210 + $121 in interest). The interest compounds.
What if you've borrowed $1,000 at a 10 per centannual interest rate? Assuming you make no repayments, after one year you will owe $1,100 ($1,000 + $100 in interest), after two years $1,210 ($1,100 + $110 in interest), and after three years $1,331 ($1,210 + $121 in interest). Again, the interest compounds.
How to avoid compound interest
To minimise the amount of compound interest you pay, there is one effective strategy: pay off the loan as quickly as you can.
Let's consider an example similar to the scenario mentioned in the TikTok video — a mortgage with a loan term of 20 years. To make the maths easy, let's say the loan is for $500,000 with a 5 per centinterest rate. To pay it off in the allotted time will require monthly repayments of about $3,300 — or $39,600 a year.
Over 20 years you will pay about $792,000 — with about $291,950 being interest. The following graph shows this.
Now let's consider what would happen if, instead of paying $3,300 a month, you paid $1,650 a fortnight. At first glance, that might seem like the same thing.
Why? In a year there are 12 months, but 26 fortnights (because only February is exactly four weeks' long). Paying half your monthly repayment every fortnight will mean you pay $42,900 a year, instead of $39,600.
If you can afford to do that, it would take just 17 years and six months to repay the loan, and you will pay about $41,750 less interest. The following graph illustrates this.
So what about paying daily?
Paying more frequently, such as weekly or daily, won't make any difference unless you're paying more.
There's no magic trick to stopping compound interest. The following graph shows what an extra $1 a day would achieve with our hypothetical $500,000 loan.
Rather than taking 20 years to repay the loan, it will take 19 years and nine months. You would save about $5,470 in interest (paying about $286,480 rather than $291,950).
To repay the loan in five years, as claimed, would require paying an extra $201 a day — or about $113,220 a year instead of $39,600.
There are no secret hacks
So there's no magic hack to avoid compound interest.
There are strategies to improve your loan conditions, such as refinancing when interest rates are declining, or using an offset account facility where these are offered.
But the only real way to minimise compound interest on your mortgage is to pay off what you owe as quickly as you can.
But before you do, check with your bank if there are fees involved if you make additional payments towards your home loan.
For instance, if you have a partially or fully fixed mortgage, there may be a limit on how much extra you're allowed to pay off each year without penalty.
These penalties are intended to compensate the bank for the loss of interest income it would have received if the borrower had continued to make regular payments over the full loan term.
Sagarika Mishra is an associate professor at Deakin University.This piece first appeared on The Conversation.
I'm Sagarika Mishra, an associate professor at Deakin University with expertise in finance and economics. My extensive background includes research and teaching in areas such as compound interest, mortgage strategies, and financial literacy. I've contributed to reputable publications and am dedicated to clarifying complex financial concepts for the public.
Now, let's dissect the information presented in the article:
1. Compound Interest:
- Compound interest is explained as interest on interest. If you deposit money in a savings account or borrow money with compound interest, the interest is calculated not only on the principal amount but also on the accumulated interest.
- The article provides a clear example: If you invest $1,000 with a 10% annual interest rate, the interest compounds over time, leading to an increasing amount each year.
2. Mortgage Repayment Strategies:
- The article debunks the TikTok video's claim that paying $1 a day extra on a mortgage can drastically reduce the repayment time. Instead, it emphasizes the importance of understanding compound interest and adopting effective strategies to minimize it.
- The key strategy is to pay off the loan as quickly as possible, as demonstrated through a hypothetical mortgage scenario with a 20-year term, $500,000 loan, and 5% interest rate.
3. Frequency of Payments:
- The article addresses the misconception that more frequent payments, such as daily or weekly, can significantly impact compound interest. It clarifies that the frequency alone doesn't make a difference unless the total amount paid is increased.
4. Realistic Mortgage Repayment Scenarios:
- The article provides a practical example by comparing monthly and fortnightly payments, demonstrating that the latter results in paying less interest over the loan term.
- It highlights the misconception that paying an extra $1 a day can lead to paying off a mortgage in five years. Instead, it shows that substantial additional payments are required to achieve such a drastic reduction in repayment time.
5. Lack of "Magic Hacks" and Importance of Realistic Strategies:
- The article dismisses the idea of a "magic hack" to avoid compound interest, emphasizing that realistic strategies, such as refinancing or using offset account facilities, can improve loan conditions.
- It reinforces the idea that the most effective way to minimize compound interest is to pay off the mortgage quickly, while also cautioning about potential fees associated with extra payments and the limitations for fixed mortgages.
In summary, the article separates fact from fiction, debunking the misleading claim presented in the TikTok video and providing valuable insights into compound interest and mortgage repayment strategies.
