Total Payments Calculation Can Be An Expensive Mistake

By on January 16, 2013

When a mortgage lender is trying to sell you a deal, you will always be given the breakdown of the loan throughout the tenor. Unfortunately, if you are not careful, you might turn your sole attention to the total payments that you will make by the end of the mortgage and make your judgement based on that information.

If the total payments for a home loan comes up to $1.25m and another one at $1m, surely the first loan is more expensive than the other one correct? Wrong. This is because you have to take into account when the payments are made. Let’s use a simple example. If you have to repay $10, would you rather repay it now or do it in 10 years? The investor’s answer is 10 years because you get to earn an interest on that $10 over 10 years. And by the time comes, inflation will have dramatically made the $10 worth much less than what it is worth now. This is investment 101.

If you want to be an investor of real estate, you have to start looking at loans and finances the investment way. Using total payments to compare between home mortgages is not a good way to judge between them. Not only is this mistake prevalent to new investors but to many experience investors as well. In extreme circumstances, you might even find that a loan with total payments that add up to half of another is actually more expensive when the time-frame factor is put under the microscope. This is even when the expensive loan has in interest rate at two thirds of the cheaper loan.

Let’s use another simplified example to drill in the point. If we are to compare between 2 mortgages for a million dollars with flat rate interest. One at 29% interest for 1 year. Another at 1% for 30 years. Which is more expensive? The first mortgage has a total payment of $1,290,000, the second has a total payment of $1,300,000. On the surface, it will look like the second mortgage is more expensive with accumulated total mortgage payments of $1,300,000. But when the time frame is factored in, it becomes blatantly obvious that $1,300,000 is actually cheaper than $1,290,000!

How is $1,290,000 more than $1,300,000?!

If you are just a home owner who wants a place to house your family, you might choose to pay $1,290,000. But when you are an investor who has to use every legal way to leverage your finances to increase you returns, be prepared to borrow big time. If you are not comfortable with leveraging your finances, maybe you should reconsider being an investor.

Now let’s use this simple theory to answer 3 common questions of property investors.

  1. If you can afford to pay for a property in cash, will it make sense to get a mortgage instead? Definite yes if the mortgage rates are less than the rate of returns that you can achieve on the property. If not, no.
  2. If you can afford to make a $500,000 down payment for a $1m property, will it make financial sense to only put down $200,000 and invest the remaining $300,000 in stocks and shares? The answer is yes. But only if the rate f return on the shares are higher than the mortgage rates that are available. If not, no.
  3. If you have cash on hand, is it advisable to partly or fully redeem your mortgage? If you have investments that have a higher return than the mortgage rates, keep the mortgage. If not, redeem the mortgage.

Some people see making a mortgage redemption as an investment in itself. This totally makes sense when the interest on your savings is considerably lower than your mortgage rates. If your mortgage is running at 5% interest while your savings are making you 1%, you are effectively making a loss of 4%. But if you put those savings into redeeming your mortgage, you will theoretically flip that 4% loss to a 4% gain. But before rushing off to redeem your mortgage, consider that you might want to leave money in the bank when you have other investment opportunities on the horizon.

Since we don’t take up mortgage loans as often as we visit the supermarket, new investors might prefer to take up loans for as short a term as possible. It is up to your personal risk tolerance and investment objectives to decide what works for you. With the common mistake that newbies make on calculating total payments, just be mindful that if you see yourself as an investor, be prepared to make decisions on maximum leverage with maximum tenor. That’s how you achieve maximum returns.



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