By paying just an extra $1 per day on your mortgage, you can hack the banking system and cut the time to pay back your home loan from 20 years to just five years.
Sounds too good to be true? Of course it is. But that doesn’t stop someone “good at finance” from making the claim in a TikTok video that has garnered millions of views and prompted dozens of other “finfluencers” to reinforce his claims.
According to the video, “The reason banks want you to pay interest monthly is because they rely on something called compound interest.” But if you pay the bank $1 every day, you’re paying “a big fat zero in interest.”
The video goes on to say that “mortgage” is a Latin word, and the reason “they” stopped teaching Latin in schools is because “they” don’t want people to understand how the banking system works.
If this sounds like a conspiracy theory, that’s because it is. Like all conspiracy theories, this one is a falsehood based on a few grains of truth, taking advantage of people’s ignorance of complicated matters.
So let’s separate the fact 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 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 converges.
What if you borrowed $1,000 at 10% annual interest? Assuming you don’t pay back, you’re out $1,100 ($1,000 + $100 in interest) after one year, $1,210 ($1,100 + $110 in interest) after two years, and $1,331 ($1,210 + $121 in interest) after three years interest) due. Again, the interest converges.
How to avoid compound interest
To minimize the amount of compound interest you pay, there is one effective strategy: Pay off the loan as quickly as possible.
Let’s look at an example similar to the scenario mentioned in the TikTok video: a 20-year mortgage. To make the math easy, let’s say the loan is $500,000 with an interest rate of 5%. Paying it off within the allotted time will require monthly installments of about $3,300 — or $39,600 per year.
In 20 years, you will pay about $792,000 – about $291,950 of which will be in interest. The following graph shows this.
Now let’s see what would happen if instead of $3,300 a month you paid $1,650 every two weeks. At first glance, that may seem the same.
Why? In a year there are 12 months, but 26 fortnights (because only February has exactly four weeks). If you pay half of your monthly payment every two weeks, you’ll pay $42,900 per year instead of $39,600.
If you can afford it, it would take just 17 years and six months to pay back the loan and you’ll pay about $41,750 less in interest. The following graph illustrates this.
So what about paying daily?
Paying more frequently, such as weekly or daily, won’t make a difference unless you pay more.
There is no magic trick to stop compound interest. The following chart shows what an extra $1 a day would yield with our hypothetical $500,000 loan.
Instead of taking 20 years to repay the loan, it takes 19 years and nine months. You would save about $5,470 in interest (you pay about $286,480 instead of $291,950).
Paying back the loan in five years, as claimed, would require paying an additional $201 per day — or about $113,220 per year instead of $39,600.
There are no secret hacks
So there is no magic hack to avoid compound interest.
There are strategies to improve your loan terms, such as refinancing when interest rates fall, or using a contra account facility when they are offered.
But the only real way to minimize compound interest on your mortgage is to pay off what you owe as quickly as possible.
But before you do, check with your bank to see if there are any charges if you make additional repayments on your home loan.
For example, if you have a (partially) fixed mortgage, there may be a limit to how much you can repay annually without penalty.
These penalties are designed to compensate the bank for the loss of interest income it would have received if the borrower had continued to make regular payments throughout the life of the loan.