Opportunity Costs Of Mortgage Mutilation
Opportunity Cost is what you give up by choosing a different path. For example if you choose to buy McDonald’s instead of cooking your own dinner for the family it might cost you, say, $30 and some of your health. Opportunity cost is the fact that although you’ve paid $30 for the meal, you could have instead spent that $30 to buy shares and earn, say, an 8% return on that $30 for the rest of your life. Obviously 8% of $30 isn’t much ($2.40) but that amount not only continues in perpetuity but can also build on itself over time compounding to vast amounts. Not bad for just skipping McDonald’s. That $2.40 each year in return is the “opportunity cost” that you give up by choosing the different path of buying McDonald’s instead of investing it. Most people are completely unaware of opportunity cost when considering various scenarios and what to do, especially financially speaking but quite often the actual cost of something can pale in comparison to the opportunity cost.
Now if the opportunity costs of saving $30 is something good, what are the equivalent things you’re forgoing by NOT Mutilating The Mortgage? Aggressively paying off our home loan for over 4 years now (and discussing it occasionally with others) I’ve heard all sorts of reasons why doing so is bad idea (or at least “not for us”). We could be spending the money upgrading our kitchen or buying useless doodads or travelling the world (this one we do do occasionally) or just generally “living it up” more so than what we currently are. But when you do these things it costs in another way rather than just the specific money you pay.
Say you’ve been reading this site for a while and have just purchased a nice big fat house resulting in you now having a $400,000 loan. You’re smart so you can comfortably afford this amount of debt (even though it is almost an insane half a million dollars) and you’ve committed to kill it in 5 years flat (assuming 6% interest). Now I’m aware that this task might not be possible for all readers/people out there but it’s just an example so don’t get your knickers in a knot!
In order to do this you’ll have to pay $3,551 each fortnight towards it as opposed to $1,102 meaning you’ll be throwing in an extra $2,449 every fortnight. In return it’ll take 5 years to pay it back and you’ll pay $63,451 in interest as opposed to $462,937 in interest had you taken 30 years. This is a saving of $399,486 in interest paid and as said above, you end up paying even more than this mental amount due to opportunity costs.
Mutilating The Mortgage is a strategic system designed so that all the pieces enable you to be as efficient as possible. As a result you get the above advantage of saving $399,486 in interest. Although you don’t physically get this money per say, you don’t give it to the bank and so instead you could do any number of other things with it once you earn it (and now don’t have to spend it on wasted interest). This $399,486 is a cost that you save by Mutilating The Mortgage. The opportunity cost you can then make is even more astounding:
Investing that $399,486 in shares (continuing our above example) at 8% would result in you receiving $31,958.88 each year in perpetuity. That’s a hefty sum although it would be eaten away by inflation over great time. To combat this you might only withdraw 5% (leaving 3% to help keep it in line with inflation) resulting in $19,974.30. This amount would be a new source of income for you for the rest of your life and also grow with inflation. It would be unending. It would be available for your children or even their children. This is but one form of opportunity cost you are throwing away by not Mutilating The Mortgage and it is how wealthy people think.
The difference between being rich and being wealthy is that one is a state of your bank balance and the other is a state of mind. You might have $2,000,000 in your bank account and be “rich” however you (like many lottery winners) might not be wealthy and spend it all away on booze and hookers. On the other hand a wealthy person thinks and acts in a way that enables them to obtain and maintain money. When a wealthy person amasses $2,000,000 they rarely loose it again. This is because they understand that once you have money you want to do everything in your powers to make sure you don’t let it go again. The reason for this is that money has the power to earn more money all by itself. You don’t have to do physical/mental labour for that $399,486 to give you $19,974.30 each year in inflation adjusting money, it just happens. Thinking in a wealthy way means structuring your life to not only be efficient at amassing money, but also ensuring that when you do get it, you keep it and use it to your advantage for the rest of your life.
But that’s not all the opportunity costs you get.
Not having any debt after 5 years will enable you to be more secure financially. It will very likely end any and all “money arguments” you have with your spouse and enable you to stop worrying about money in general. This then again has further added benefits in that your long term health will be better due to reduced stress and the ability to have more time to take care of yourself (again saving you even more money from medical expenses). The multiple layers of compounding reverberate out through all aspects of your life for many years. You might be able to start that risky business you wanted to start because now you’re much more financially secure than before. With no home loan to pay off that new business might just get the funding capital it needs to sky rocket you to unbelievable success and on and on it goes.
If none of this is sounding nice to you do note that this compounding effect also applies in reverse to people who DON’T mutilate their mortgage and instead spend their money on higher living expenses or inefficient ways of living. You don’t just get stung $399,486 in extra interest, you are also likely more stressed, are more likely to have money troubles, are more at risk during times of financial catastrophe, are less likely to do risky things that may improve your life. It’s like a punishment that keeps on going on scolding you in every part of your life for years and years. Who’d want that?
Now as I said above, a lot of people might not have the ability to pay off $400,000 in 5 years, however don’t let that stop you from trying. Too often I hear the excuse that “putting 70% of your income towards your mortgage is just too much” and so they just give up then and there, continuing on paying the minimum (or a few hundred extra at best). More often than not the person just either isn’t ready to admit that paying off their mortgage quicker is smarter than whatever it is they’re currently doing or that they just “don’t care” or aren’t interested. In this case trying to convince them isn’t about logic or numbers but more about just giving them information and letting the idea sink in. I always advocate throwing at least 70% of your after tax income (or more) at your mortgage but it’s not like “only” throwing 60% is a grievous sin that you’ll be punished in hell for. If 60% is all you can get for now then excellent! If 20% is all you can get then well done too. In these cases be happy with your results but know that there is still more you can do. Australia may be an expensive place to live but trust me, it’s not just possible to live a simpler and cheaper life, it’s far better for your health and mental state both now and more importantly in the future.