You can’t beat the bank by paying $1 a day extra on your mortgage. Here’s how compound interest really works

By paying just $1 a day extra on your mortgage, you can hack the banking system and cut the time to repay your home loan from 20 years to just five years. (Pixabay photo)

By paying just $1 a day extra on your mortgage, you can hack the banking system and cut the time to repay your home loan from 20 years to just five years.

Sounds too good to be true? Of course it is. But that hasn’t stopped someone “good at finance” from claiming this in a TikTok video that’s garnered millions of views and spurred dozens of other “finfluencers” to amplify its claims.

According to the video: “The reason banks want you to pay interest monthly is because they rely on a thing called compound interest.” But if you pay the bank $1 every day you “will pay a big fat zero in interest”.

The video goes on to say “mortgage” is a Latin word, and the reason “they” stopped teaching Latin in schools is because “they” don’t want people understanding how the banking system works.

If this sounds like a conspiracy theory, it’s because it is. Like all conspiracy theories, this one is a falsehood built on a few grains of truth, taking advantage of people’s ignorance about complicated matters.

So let’s separate the facts from the fiction.

What is compound interest?

Compound interest, in a nutshell, is interest on interest.

Say you put $1,000 in a savings account that pays 10% interest. After the first year, you would have $1,100 ($1,000 + $100 in interest). At the end of the second year you will have $1,210 ($1,100 + $110 in interest). At the end of the third year you will have $1,331 (1,210 + $121 in interest). The interest compounds.

What if you’ve borrowed $1,000 at a 10% annual interest rate? Assuming you make no repayments, after one year you will owe $1,100 ($1,000 + $100 in interest), after two years $1,210 ($1,100 + $110 in interest), and after three years $1,331 ($1,210 + $121 in interest). Again, the interest compounds.

How to avoid compound interest

To minimise the amount of compound interest you pay, there is one effective strategy: pay off the loan as quickly as you can.

Let’s consider an example similar to the scenario mentioned in the TikTok video – a mortgage with a loan term of 20 years. To make the maths easy, let’s say the loan is for $500,000 with a 5% interest rate. To pay it off in the allotted time will require monthly repayments of about $3,300 – or $39,600 a year.

Over 20 years you will pay about $792,000 – with about $291,950 being interest. The following graph shows this.

Now let’s consider what would happen if, instead of paying $3,300 a month, you paid $1,650 a fortnight. At first glance, that might seem like the same thing.

Why? In a year there are 12 months, but 26 fortnights (because only February is exactly four weeks’ long). Paying half your monthly repayment every fortnight will mean you pay $42,900 a year, instead of $39,600.

If you can afford to do that, it would take just 17 years and six months to repay the loan, and you will pay about $41,750 less interest. The following graph illustrates this.

So what about paying daily?

Paying more frequently, such as weekly or daily, won’t make any difference unless you’re paying more.

There’s no magic trick to stopping compound interest. The following graph shows what an extra $1 a day would achieve with our hypothetical $500,000 loan.

Rather than taking 20 years to repay the loan, it will take 19 years and nine months. You would save about $5,470 in interest (paying about $286,480 rather than $291,950).

To repay the loan in five years, as claimed, would require paying an extra $201 a day – or about $113,220 a year instead of $39,600.

There are no secret hacks

So there’s no magic hack to avoid compound interest.

There are strategies to improve your loan conditions, such as refinancing when interest rates are declining, or using an offset account facility where these are offered.

But the only real way to minimise compound interest on your mortgage is to pay off what you owe as quickly as you can.

But before you do, check with your bank if there are fees involved if you make additional payments towards your home loan.

For instance, if you have a partially or fully fixed mortgage, there may be a limit on how much extra you’re allowed to pay off each year without penalty.

These penalties are intended to compensate the bank for the loss of interest income it would have received if the borrower had continued to make regular payments over the full loan term.

Sagarika Mishra, Associate professor, Deakin University

This article is republished from The Conversation under a Creative Commons license. Read the original article.