Learn how a longer mortgage with a lower interest rate can free up money for investing in index funds, leading to long-term wealth building. Discover the balance of saving and spending with a longer mortgage.
When I was growing up, it was an ambition of most of the older people I knew to buy a house and then as soon as a house was bought, the next most important thing to do was to pay it off as quickly as you could. When I started thinking about personal finance as a finance student at University, my view was this was an outdated idea.
Admittedly, it would be great to have a house which was paid off, but as a student one of the most important terms a finance/economics student learns is opportunity cost. So let’s think about why a longer mortgage may be a better idea for “some” people.
One of the biggest barriers that people have to start investing is a set monthly amount to put aside in order to invest. This is the big struggle, with so many things to buy and limited resources (monthly salaries), it can be difficult to get started.
One way of creating some extra monthly income is to take a longer-term mortgage. Now, you may read this with scepticism, you too have probably been encouraged to buy a house and pay it off quickly, however, let’s think about the benefits of a longer-term mortgage.
Well first off, some longer-term mortgages can have lower interest rates. This is not always the case, but over a longer period, a lender can have more confidence that the borrower is more likely to be able to meet the repayments. The simple reason why is that the monthly repayments are lower.
Ok, so let’s talk it through logically. If your mortgage is 1200 per month over 25 years, and 900 per month over 40 years, investing the 300 in a low-cost index fund might be a great option for many people. Yes, would pay more towards your mortgage in the last 15 years and the total interest will also be higher but think about the potential earnings of investing 300 a month in a low-cost index fund over 40 years.
Investing in an index fund is a great way to build wealth over time. It allows you to take advantage of the long-term growth of the stock market. By investing any monthly savings you have into an index fund, you can earn a higher return on your money than you would by putting it towards paying off a shorter mortgage with a higher interest rate.
Another advantage of having a longer mortgage is that it gives you more flexibility in managing your cash flow. With lower monthly payments, you can maintain a better balance between saving and spending. The other thing with mortgages is they are incredibly inflexible, let’s say that you are between jobs at some point in your career, a natural thing to do is to reduce spending, but mortgages are typically inflexible, but investing in financial markets are not, you could skip payments for half a year without the worry that your house would be re-claimed by the bank if you skipped payments on your mortgage.
Now, it’s important to remember that like any financial decision, the choice between a shorter or longer mortgage should be based on your specific financial situation and goals. It’s a good idea to consider your income, expenses and overall financial health, and consult with a financial advisor before making a decision. Take a look at the ETFs section of our site to see the benefits of investing in index funds over a long period. Also, remember that investing in financial markets is risky and investments (particularly over a short period of time) can go down.
Let’s look at the maths
The amount of interest you would pay on a mortgage depends on the loan amount and the interest rate. However, I can give you an estimate of the difference in interest between a 25-year and a 40-year mortgage at a 4% interest rate.
Let’s say the loan amount is £300,000.
- For a 25-year mortgage at 4%, the monthly payment would be about £1,432 and the total interest paid over the life of the loan would be about £172,957.
- For a 40-year mortgage at 4%, the monthly payment would be about £1,288 and the total interest paid over the life of the loan would be about £329,141.
- So, as you can see, even though the monthly payment is lower on the 40-year mortgage, the total interest paid over the life of the loan is significantly higher.
Now the difference between the monthly payments is 1432 – 1288 = 144.
If you invested £144 per month for 40 years at an 11% annual interest rate, your total investment would be £86,880 (£144 x 12 months x 40 years)
The total amount of interest earned over the 40-year period would be £2,874,838.77. (using the formula A = P(1 + r/n)^(nt) where A is the total amount, P is the initial principal, r is the interest rate, n is the number of times that interest is compounded per year, and t is the number of years).
Keep in mind, this is just an estimate and actual returns may vary depending on the actual interest rate and other market conditions, and this calculation doesn’t take into account taxes and other fees, so it’s always best to consult with a financial advisor! For some people, it would not be suitable as they would require a shorter mortgage, but for many people especially younger people buying a house, it could be a sensible idea!
If you’re looking to become a savvy investor, our previous post is a must-read about navigating the complexities of ETFs. Gain valuable insights and tips by following the link to access it.