This article was originally published here in May 2003
In last months article I showed you how compounding interest can have a powerful growth effect over time. This month I will take a look at what is essentially the reverse effect, compounding debt interest. Most people will experience this effect through their mortgage, so I will use this as an example.
Just a few years ago there were only two types of mortgages, endowments and repayments. I suspect that the main reason endowment mortgages became popular is because they were an early tax-free saving scheme. In the high tax and high inflation days of the 1970’s they must have seemed a great idea. With today’s declining stock-markets endowment maturity values are falling short and leaving homeowners with mortgage debt still outstanding. These days most people opt for the lower risk repayment version.
Recent financial deregulation and the booming housing market (which many, including myself, would call a bubble waiting to burst) have encouraged innovation from the mortgage providers. The old style repayment mortgage has been given a makeover and now sports several personalities. This list of best-buy mortgages details 10 different forms of mortgage. However, underneath the branding, they all perform in a similar manner.
With a repayment mortgage you pay a small part of the outstanding debt back each month, along with interest on the remaining debt. In order for you to pay the same amount each month throughout the life of the mortgage your payments are structured initially so they repay mostly interest and only a small amount of the debt. As the capital is paid back the interest payments decline and the debt repayments grow until the entire mortgage is paid off.
Such non-linear behaviour is hard to model in a spreadsheet. A friend of mine was happy to get his spreadsheet to agree to within a few pounds of his mortgage projection. It is well worth the effort to create such a spreadsheet. Use it to check the statements from your bank or building society; you may find errors in their favour.
Let’s create a simple spreadsheet to show how much money you can save by repaying a little money earlier than the bank demands. Launch your spreadsheet application and create a new document. In cell A1 enter the value 100000, our example starting debt. In cell A2 enter the formula =A1-4000. This simulates a £4,000 repayment of debt each year. Copy the contents of cell A2 and paste into cells A3 through A25. In cell B1 enter the formula =(A1-(A1-A2)/2)*0.05. This represents the interest payable on the average debt outstanding throughout the year (the interest rate here is 5%). Copy cell B1 into cells B2 through B25.
You will see that the interest payments drop throughout the twenty-five life of the mortgage as the outstanding debt declines. If mortgages really worked this way by the end of the mortgage you would be paying less than half the initial repayment. That is why with a real mortgage the repayment amount starts low and increases.
Now for some experimenting. Change the formula in cell A2 to be A1-5000, simulating an overpayment of £1,000 a year. Copy cell A2 into cells A3 through A21. You will see that the outstanding debt reaches zero at the end of the 20th year, five years early. Summing the interest payments in cells B1 through B20 shows a reduction of £12,500, quite a saving. Obviously such a large repayment may be hard to achieve in real life. Try changing the repayment levels to see the effect. Remember this simplified spreadsheet underestimates the real effect of early repayments, your actual interest payment saving will be higher.
It is easier to overpay some mortgages compared to others. Your options are usually limited if your are in an initial discount period of your mortgage or if yours is a fixed rate mortgage. Check the small print for any limiting clauses. A number of my friends have Current Account Mortgages. These pool together your mortgage, savings, current account and credit cards. Any spare money in the account is used to reduce the interest payments. If you have the financial discipline a CAM can be a great money saver.
I hope these articles have shown you how you can use your spreadsheet program to create financial models. Experimenting with various parameters can help to decide on how to save or make money.