Optimization

February 24, 2022

Albert Einstein called it the eighth wonder of the world. Warren Buffett, the greatest investor of all time attributes much of his success to the power of compounding. His net worth was $1M at age 30 and $4B at age 60. Greater than 90% of his $90B fortune was accumulated in the 30yrs after he became a sexagenarian. A mortgage also seems to last 30 yrs. If you are wondering how to use a mortgage to build wealth, read on.

The answer is simple, compound mortgage principal, not interest. While the answer may sound straightforward, it requires a more nuanced understanding of the two ways equity is built in a home.

First, a mortgage is a position of financial leverage for homeowners; therefore, 100% of home price appreciation belongs to the homeowner. In a thought experiment, let's assume a 10% downpayment on a home today and prices increase 20% tomorrow. The mortgagor (homebuyer) will then own 25% of the home, while mortgagee's (the bank) loan amount remains constant. The math works as follows -> (10% down payment + 20% price increase) / 120% of original home value = 25% equity. The takeaway is that homeowners disproportionately build equity in a mortgaged home as price appreciates. Compounding kicks in over time, just like for Mr. Buffet. If home prices increase 2% a year, the nominal value of a home will double in 35yrs (not 50) and assuming no principal contributions (for the thought experiment), the homeowner has a net equity position of 55% (10% down payment + 100% price increase / 200% of original home value).

Second, additional equity is gained in a home when mortgage payments are made each month. The amount of a monthly payment is fixed over the lifetime of a loan, but the proportion of interest and principal varies each month. An amortization schedule determines the changing ratio of principal and interest each month. Amortizations also front load interest, but contrary to a popular misconception, mortgages use simple interest. Borrowers pay the entire "simple" interest due at the end of each month. A small portion of principal is also paid each month such that the principal balance reduces to zero over the mortgage term. There is no compounding of principal if you stick to your amortization schedule. In fact, the total interest for the loan life is estimated upfront and reported in TIP (total interest percentage). For example, A $500,000 loan at 4% fixed rate over a 30 yrs has a TIP is 72% or ~$360,000 in total interest. Monthly payments are fixed at a$2387. In month 1 interest and principal are $1667 and $720 respectively. In month 2 interest and principal are $1664 and $723. Roughly $3 shifts over each month from interest towards principal.

Amortization schedules are not set in stone. You can deviate from the preset change in proportion of P&I. Many of us have heard that making extra payments of small amounts towards a mortgage is beneficial, but it isn't always clear why it's beneficial. If you pay an extra $150 towards principal in month 1, about $0.5 less interest is owed vs the planned amortization schedule in month two. If you repeat an extra payment in month 2, $150.5 is automatically applied towards principal. This deviation from the amortization plan increases the rate at which principal is paid down or compounded. As a result, your total interest drops precipitously and homes can be paid off 5-10yrs faster. Compounding any investment takes time and patience is a virtue that is required to build wealth. If Warren Buffet had stopped compounding his money at age 60, he would have still been a billionaire, but not an extremely famous one.

Use our calculator to understand the best amount of extra payments to compound principal. Everyone's situation is different and the answer changes based on interest rates. Don't settle for less, start compounding!