Albert Einstein, Your Mortgage, and the Magic of Compound Interest

“Should I pay my mortgage bi-weekly?”

"How fast can I pay off my mortgage if I make an extra payment per year?”

“What will an extra $500 a month do to my principal balance?”

These are all great questions I get asked regularly and I always light up with excitement when it happens because in answering these questions, I get to put on my educator hat (which fits much more comfortably than my salesman hat) and talk about something that utterly fascinates me; compound interest.

Albert Einstein once said something along the lines of “compound interest is the most powerful force in the universe.” Others argue that he deadpanned “compound interest” when asked what the most significant invention of the modern world was from his perspective. Some say none of this happened but that Einstein called compound interest the “8th wonder of the world”. Yet some say he never said anything like this and had no concern for the likes of predatory banking strategies…but I digress.

Historians can debate the merit of this urban legend but the point should be taken regardless; compound interest truly is an amazing force, and it can be manipulated to and fro for one’s own benefit, something banks and billionaires have been doing for a long, long time.

Let’s look at a practical example of this universal power working in your favor, in the form of a modest (but disciplined) monthly investment over an extended period.

**Warning - gory math below**

If one could be so disciplined to set aside $200 a month, invested at a 6% rate of return and compounded monthly, they would realize a total of over $93,000 in 20 years. This represents a $45,000 profit on a $48,000 principal investment (240 months x $200 = $48 K). Not too shabby, right?

That same amount over 30 years becomes $202,100 and by year 40, a lifetime of modestly saving $200 a month, you’d have over $400,000 on only a $120,000 principal investment. WOW!

Let’s take the governor off this bad boy and look at what a $1,000 monthly investment at an 8% return looks like over 30 years: $1,501,295!! That’s right, you read that correctly, under this scenario a $360,000 principal investment is worth over $1.5 MM after 30 years due to compound interest!!

Powerful indeed and something that should be common knowledge, but do they teach this stuff in school? Unfortunately, they do not, you must read blogs on the internet to learn this stuff! Now, that we’ve got a taste of its power, let’s see if we can figure out how to use the mathematical wonder of compound interest to beat the bank when it comes to your mortgage.

That’s right, banks have the compound interest game on lock and your mortgage is the perfect example. Think about your mortgage payment for a moment, in fact if you’re able to, go get it or pull it up online.

Now be sure to remove any taxes or insurance from the payment before you start banging away on a calculator (general rule to follow when discussing payments or rates). Once you’ve identified the sum of the principal and interest portion of your payment, multiply it by the number of months you took the loan out for (15 years = 180 months, 20 = 240, 30 = 360).

I’ll wait here for a moment while you pick yourself up off the floor. You may need a tissue to wipe those tears. In the meantime, your bank is crying tears of joy. For those of you who haven’t already pulled out their own mortgage statement, let’s look at the example below:

A $300,000 principal loan amount amortized over 30 years (360 payments) at an interest rate of 5.25% nets monthly principal and interest payments of $1,657. If you were to make this minimum monthly payment for 360 consecutive months, you would spend over $596,000 paying off your $300,000 mortgage!

Fair or not, this is just the way it works and a big reason banks can package these loans together in bulk and sell them off on the secondary mortgage market; there’s a gazillion dollars of profit at stake!

Now that we’ve seen how compound interest benefits the banks, let’s explore how we can put its “8th wonder” power to work for you, the fearless homeowner.

In this first example, we’ll explore what would happen if we paid an extra $343 a month, on top of the $1,657 principal and interest on our $300,000 mortgage, for a total payment of $2,000.

This manageable extra payment would pay the $300,000 note off in 245 months (as opposed to 360). This represents savings of 115 payments of $1,657. By paying an extra $343 a month for just a little over 20 years you shave almost 10 years off your loan, saving yourself over $191,000 in additional payments and in the process, limit the bank’s profit substantially.

The numbers only get crazier when we up the ante, so let’s look at what kind of damage an extra $843 a month ($2,500 total payment) would do to improve the financial livelihood of your family.

$2,500 a month thrown at this 5.25% interest rate we’ve been modeling would pay our $300,000 loan off in only 171 months (14 years 3 months). This amount totals just over $427,000; a far cry from the $596,000 we’re paying the bank under the original loan terms.

Now I get that not everyone has an extra $800 a month laying around, especially when you can get a new Audi or run up a ton of credit card debt for $800 a month, so let’s explore a more practical and manageable practice; bi-weekly payments.

The trick here is in the verbiage. Notice, bi-weekly payments call for a payment every two weeks (26 payments a year), as opposed to semi-monthly (24). If you’re making 50% ($828.50) of your payment every two weeks, you are effectively making 26 payments. This equates to one additional full payment per year.

This simple and easy to budget change to how you pay your mortgage can have a pretty substantial impact on the money spent over time. This one extra payment per year would shave 60 payments off the total life of the loan. This represents savings of over $99,000 in payments, in addition to the 5 years of your life free of a mortgage payment!

So, when people ask me “Can I pay additional principal without penalty?” Or “Should I set up bi-weekly payments?”

My answer is always “Hell yes! You can and you should!!!”

Ask your lender if they can set up bi-weekly payments for you from the onset. Most banks do not offer this convenient arrangement for reasons that should now be quite evident, but there are a few lenders out there who will allow this (shameless plug: my employer is one of them).

If your lender won’t allow this, I strongly caution you against responding to any of the third-party snail mail marketing you will receive post-closing, and you will receive a lot if you’re in Arizona, offering to set up this bi-weekly payment for you. Many of these companies will charge you fees to do so and they aren’t making payments in real time, they bank them and make one additional payment per year, as opposed to the smaller additional principal payment every two weeks.

The bi-weekly frequency of these payments against an ever-shrinking principal balance is where the magic happens. Some of these third-party companies rob you of that magic, making their money on that margin.

With a little self-discipline, you can just as easily set up an automatic recurring payment through your online banking and accomplish the same feat. If you can, I recommend paying up one month ahead of time to protect yourself against any confusion or missed payments.

Hopefully, you now see what Albert Einstein was talking about when he called compound interest the “best thing since sliced bread” (wait, what?) and you’re now equipped with a practical way to put it to work for you.

P & L

Greg Geisler | 602-999-5361 | [email protected] | NMLS 627951