The good and the bad of compounding interest

Balance: Remember, compounding works exactly the same for borrowers as for investors. If the term is short, the interest can be minimal. But as the term is stretched the interest bill becomes horrendous.
Balance: Remember, compounding works exactly the same for borrowers as for investors. If the term is short, the interest can be minimal. But as the term is stretched the interest bill becomes horrendous.

For years I have been talking about the power of compounding. The amount of money you have when you retire depends primarily on how soon you start, and the rate of return you achieve and the rates effect grows exponentially as time increases.

Invest $4000 a month at 5 per cent for 25 years and you end up with $2.2 million; extend that term to 35 years and the amount jumps to $4.33 million.

Given the indisputable mathematics, you can understand my horror when I heard that some lenders are considering offering home buyers mortgages over 35, or even 40 years. The justification appears to be to encourage home affordability in fact it would blow out the banks profits, and create a minefield down the track.

Remember, compounding works exactly the same for borrowers as for investors. If the term is short, the interest can be minimal. But as the term is stretched the interest bill becomes horrendous.

Think about a couple aged 30, who want to borrow $400,000 to buy their first home. If they get a mortgage of 4.5 per cent over 25 years the repayments will be $2223 a month, with total interest payable of $267,000. If the loan term was 35 years, while the payments would drop to $1893 a month, the interest payable would leap to $395,000. Thats $128,000 more for that couple to pay.

When you consider that all payments are in after-tax dollars, its even more scary. For somebody in the 39 per cent tax bracket, including Medicare, the pre-tax equivalent of those extra interest payments is $210,000 a huge slice of their pre-tax earnings over that period.

But there's even more to this than the interest payable. A couple who choose a 25-year term get to age 55 with their home paid off and $2223 a month available for investment. If they invest that into a good Australian share trust, returning 9 per cent per annum income and growth, they would have an additional $405,000 at age 65 and $783,000 at age 70 if they decided to let the portfolio grow.

In contrast, a couple whose loan term is 35 years get to age 55 with a debt of $183,000 still to pay off, and with 10 years of mortgage payments ahead of them. They will celebrate their 65th birthdays by making their final loan repayment.

Home ownership is a worthy goal, and I do appreciate that (due largely to the relentless cutting of interest rates) home prices have way outstripped average wages. However, the way to solve the problem is not to keep providing incentives to make it easier and easier for first home buyers to enter the market. All that does is push up prices and put under-resourced home buyers at risk.

One of the worst things that could happen to a first home buyer would be to lose their home because the repayments become out of their reach. Yet for borrowers who can only just afford their repayments, this could easily happen due to a change of circumstances, such as loss of a job, serious illness, or interest rate rises.

Australia's regulators need to remember that the genesis of the global financial crisis was President Clinton's belief that every American was entitled to home ownership, irrespective of income or assets. This led to billions of dollars of bad debts, repossessions and plunging real estate prices. Australians can't afford for this to happen here. Our priority should be to teach people how to save.

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Question. I would like to know how Centrelink determines assets after one partner passes away when receiving an age pension. If I bequeath assets in my name to other parties such as charities, children etc in my will, does Centrelink regard this as gifting and therefore reduce the pension for the surviving spouse.

Answer. Centrelink has no problem with assets that are bequeathed in a will. The main problem arises when people do not take advice when making their will and leave the bulk of their assets to their partner. This may well take the survivor over the assets test cut-off point and they end up losing their pension as well as their partner. It is too late to try to give assets away, once the will maker has died.

Question. In a response regarding gifts to children you mentioned that in your opinion an interest free loan was the way to go. However, you did not explain why. What is the difference between a gift and forgiving the loan in future? Could you please clarify.

Answer. That specific question was from the parents of a young person. If they make a gift now, and the child has a relationship breakdown, part of that gift may be lost to the other partner. If the money is made as a loan, documentation can be prepared to protect it for the person it was intended for. But if the parents are thinking about becoming eligible for the pension at some stage a loan would still be counted as an asset. This is why it could be beneficial for them to forgive the debt in the future when they were satisfied that the son's future was fine.

  • Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. noel@noelwhittaker.com.au