Scott Francis 29 April 2013
Summary: Paying more than the minimum on your mortgage from the first year saves interest for the life of the loan – much like starting a regular saving or investing program.
Key take-out: Now is the time to pay extra on your home loan.
With the cash rate sitting at 3%, and many mortgage rates, both fixed and variable, having a 5 in front of them, there is an argument that borrowers have never had it so good. There remains a counter argument – that with house prices at close to record highs compared to the average income, many people have borrowed more money to buy a house than ever before. These people are exposed to sharp increases in interest rates. Either way – with record low interest rates and some people managing large mortgages, now is a time to think about how mortgages work, and what you might do with that information.
The benefits of committing to regular additional repayments
Many people are aware of the benefit of making extra repayments toward their home loan. However, few can articulate the full benefit of the strategy, which is more powerful than just decreasing the balance of your home loan by the amount you pay off.
There is a three-fold benefit from making extra repayments, being:
1. You reduce the amount of your loan by the extra repayment. Let’s say you receive a $1,500 tax refund and add that to your loan, you directly decrease your loan balance by that $1,500.
2. Every future repayment becomes more effective, because now that you have $1,500 less interest being added to your loan each month. This might only be an extra $90 less of interest each year, but over a long period (25 years) it adds up. And, if you make a habit of extra repayments, your additional repayments will be much more than just $1,500. This also demonstrates the advantage of early additional repayments. An extra repayment in the first year saves interest for 25 or 30 years (depending on the term of the loan) – much like starting a regular saving or investing program, the early you start making additional repayments, the better the results.
3. You reduce the overall riskiness of your financial position by being ahead in your loan repayments – for example, it will give you greater ability to manage your home loan if you are in a position where your income is interrupted for a period, or lower than hoped for a while. Many people have loans that account for more than 50% of their after tax-income. Committing such a high proportion of income to a loan leaves little room if that income is impacted for any reason.
A strategy - Making repayments assuming an interest rate higher by 2.5%
So what to do when you put this information all together – including the record low current mortgage rates and the possibility that they will rise in the future? A person with a $400,000 mortgage, currently at an interest rate of 5.5%, has mortgage repayments of $2,466 a month (assuming monthly fees of $10 a month – all calculations from moneysmart.gov.au). If the loan were at an interest rate 2.5% higher, it would be 8% a year. Repayments would be $3,097 a month. My suggestion would be that repayments be started at this level. It gives the homeowners greater ability to handle any interest rate rises because they are already making higher repayments and reducing their mortgage, they will save interest and quickly reduce their loan balance. In fact, total repayments under this scenario (assuming the interest rate stays at an average of 5.5%), will be $610,000 over 16.5 years, rather than making the minimum repayment which will see them pay $740,000 in repayments over 25 Years. A sizeable difference.
The Tough Reality – Early Repayments Are Largely Interest – And the Opportunity
Back to our $400,000 loan at 5.5% interest. The first year’s total repayments will be $29,600. And – the tough news – our loan will only have only decreased in value by $7,700. After the hard work of spending $29,600 of after tax dollars on the mortgage it will have reduced by less than one-third of this amount, and will still stand at $392,300.
The opportunity is this. Increase your mortgage repayments from $29,600 to $37,300. That is an increase in mortgage repayments of 25%. You effectively double the effectiveness of your repayments – a 100% increase in effectiveness – and reduce your mortgage by $15,400 instead of just $7,700. This works for any increase in repayments. A $1,000 increase in repayments is a 3.4% increase, and leads to a 13% further reduction in the home loan being reduced.
Looking at the maths – it is true that early repayments are largely interest, but that means that extra repayments can quickly increase the effectiveness of repayments.
Inflation, increasing income and loans
A quick final point. Inflation is on your side once you tackle your loan. All being equal, the ‘real’ (after inflation) cost of your loan falls over time. I remember headlines from years ago (I was only a kid) when average house prices went through $100,000. Today a $100,000 loan to buy a house looks positively friendly. Along with inflation comes rises in income. Today’s average income of around $72,600 (as measured by AWOTE – Average Weekly Ordinary Time Earnings) has basically doubled for someone who took out a loan 15 years ago when average wages were $36,400. Initial repayments for a loan that would have looked daunting for them in 1998 would look more reasonable against their current income.
So, with a strategy for extra repayments, and with inflation eating away at the real value of your mortgage and incomes likely to rise, a home loan should become increasingly less daunting over time.