ANZ Finance blog | Tipping Point | McGraw Hill Australia New Zealand

Yes Virginia, there is a Mortgage Tipping Point

Published 2 October 2020

By Dr Peter J Phillips, Associate Professor (Finance & Banking) University of Southern Queensland

Tipping Point -- McGraw Hill ANZ Finance Blog -- Australia and New Zealand

Tipping points seem to be a universal fact of life. If you look hard enough, you can find them everywhere. In strategy games, you can feel when you are on the verge of a big win. In sports, you can feel it when your team is just one point away from sweeping to victory. And if you can reach your mortgage tipping point, you will feel that you are on the verge of seeing all your hard work pay off. Importantly, what once felt like an impregnable fortress or an unclimbable peak will seem, suddenly, likely to yield to your hard work. You can win. And if you press on, you will win.

A mortgage tipping point is the point beyond which you are paying more principal than interest. Up until then, you are paying more in interest than you are in principal and the loan balance remains stubbornly close to the amount you borrowed. Progress appears slow and it seems to take forever to get anywhere. Once the tipping point is reached, however, your mortgage payments are mostly additions to your own wealth rather than additions to your bank’s wealth. And the advantage builds in your favour as you get closer to paying off the loan. It seems that most people would like to reach this mortgage tipping point as quickly as possible. So where is it? How can it be reached? What factors stand in the way? Are there obvious mistakes that could be avoided?

First, let’s set down a few basic loan examples to see how much it takes to repay a mortgage:

$500,000 loan, monthly payments at 5 percent interest over 30 years. The monthly payment is $2,684 (over 30 years, there are a total of 360 payments totalling $966,278);
If the loan was $700,000 at 5 percent over 30 years, the monthly payment is $3,757 for a total to be repaid of $1,352,790;
If the loan was $300,000 at 5 percent over 30 years, the monthly payment is $1,610 for a total to be repaid of $579,767.

When will the tipping point be reached? Interestingly, the amount of the loan doesn’t determine the tipping point! The two factors that determine the number of months until you reach the tipping point are: (1) the interest rate; and (2) the term of the loan. This is really surprising but we have to be careful not to fall into the trap of thinking that the amount is irrelevant.

The tipping points for each loan are as follows. For a mortgage at 5 percent p.a. and 30 year term, if we took out a loan in 2020, our tipping point would be reached around 2039. If the interest rate was 3 percent, the tipping point would be reached around 2033. If the interest rate was 7 percent, the tipping point would not be reached until almost 2041. Over 30 years, then, the advantage is in the bank’s favour two-thirds of the time unless the interest rate is very low. Even at a very low rate, the tipping point is around the mid-point of the loan term.

Now let’s look at what we can do to reach the tipping point sooner. We mentioned that the loan amount doesn’t determine the tipping point but does this mean that it doesn’t matter how much you borrow? No, of course not!

You can see from the repayment figures that we presented above that a loan is a very expensive commitment, even with a rate of around 5 percent, which is actually historically quite low, it still takes around $1,600 per month to pay off a relatively low mortgage amount of $300,000. And you still have to pay back nearly $580,000… Remember, this is money you have to earn through hard work. The more you have to pay back, the more (and longer) you have to work and the less you have to invest in wealth creating assets like shares (or superannuation in general).

The reason why the amount that you borrow matters is not because it technically determines where the tipping point is. Rather, it is because the more you borrow, the harder it is to make the extra payments needed to bring the tipping point forward and, consequently, the longer the loan stays in your bank’s advantage. Even modest extra repayments make a big difference. For each of the loans mentioned above, an extra $100 a month has the following effect:

$500,000 loan at 5 percent over 30 years: an extra $100 per month saves 2 years and 4 months and almost $43,000 off the total repayments;
$700,000 loan at 5 percent over 30 years: an extra $100 per month saves 1 years and 8 months and almost $44,000 off the total repayments;
$300,000 loan at 5 percent over 30 years: an extra $100 per month saves 3 years and 8 months and almost $40,000 off the total repayments.

The more extra payments you make, the sooner you reach the tipping point, the more you save and the less years of work you have to do to pay your bank. Here, an extra $100 per month saves $40,000… That’s a lot of months’ work saved!

In sum, having watched my fair share of real estate shows, it is easy to see how people can let status and image get in the way of winning the ‘long game’. A more modest house (or as modest as you can get in your town) might not exactly be the best way to impress people but if you start modest you can reach your tipping point sooner and more easily. Then, if you like, you can trade up and reach the next tipping point sooner and more easily and so on. Or perhaps, seeing your friends pay for the heating and cooling of a big house, not to mention repairing it, furnishing it and cleaning it, you might decide that a modest house is the best headquarters from which to grow your family’s long term wealth.

Discussion Question

Go online and use your bank’s mortgage calculator to run various scenarios. Also, many banks have an ‘extra repayments’ calculator. Re-run some of the above examples and see how dramatic the effect of extra repayments can be.

Further Reading

In Chapter 10 of the textbook, we discuss how to work out the loan amount for a mortgage. If you are super keen, run a few calculations by hand. And remember, use this knowledge to help yourself, your friends, your family and community.