Understanding mortgages - ABC radio material
According to a Sydney Morning Herald, article on September 18, 113,000 households are currently experiencing mortgage stress, and at least 600,000 households are likely to experience mortgage stress by the end of this year.
Australians are forced to take bigger mortgages than every before, because of rising house costs, making a mortgage a significant and long-term financial relationship.
So is it better to rent or buy?
There is no right or wrong answer to this question. Many people like the idea of owning their own house and the control that it gives them. At the moment it is generally cheaper to rent rather than buy because property yields are reasonably low.
An example would be to examine the difference between renting and buying a two bedroom unit in Toowong. The unit is advertised as being $315,000 so it would be fair to assume it will sell for around $300,000.
A $300,000 mortgage over 30 years has monthly repayments of $2,100 (interest calculated at 7.5 per cent). Add to this body corporate fees of $300 a month ($3,600 a year) and repairs or maintenance of around $167 a month ($2,000 a year) and your monthly cost blows out to $2,567.
To rent a similar unit costs around $290 a week, equating to $1256 a month.
In this (real) case, the cost of renting is less than half the cost of ownership. If the person renting were to be saving the $1,300 a month, they will certainly get ahead financially. However, if they spend the $1,300 a month on dining out, travel and other lifestyle indulgences, then the person paying off the property will end up ahead financially.
Perhaps renting for a while, saving the difference and then buying a property makes sense.
What cushion do you need to cover mortgage repayments?
If you wanted to buy the unit in the previous section, which had a mortgage of $2,100 a month, and the only repayments you could afford were the $2,100 a month then you would be taking a real risk in buying the property because if interest rates were to rise you would not longer be able to afford the repayments. Sure you could fix your loan but when the fixed period is up - say in 3 to 5 years time - you will still be facing markedly higher interest rates.
I think allowing for a 3 per cent interest rate rise, and starting to make those repayments immediately makes great sense.
In the example from the previous section that would be to allow for repayments of the loan at a rate of 10.5 per cent, or repayments of $2,765 - an extra $665 a month. Why allow this buffer? We know that interest rates have twice peaked at well above 15 per cent in the last 30 years, so allowing for potential interest rate rises is important. You don't want to have to sell your home during an interest rate peak when other people are forced to sell their homes and buyers have to borrow at high interest rates and are not able to afford to pay as much to buy properties.
What are the Benefits of Extra Repayments?
Making extra repayments make sense on three levels.
As you get ahead with the mortgage repayments, you lessen the chance of 'mortgage stress' in the case that interest rates rise, your income falls or other unexpected costs arise. As you decrease your loan, you decrease the risk of stress linked to your loan.
Every extra dollar that you pay into the mortgage works to reduce the mortgage. In contrast to this most early repayments to a mortgage are almost all interest repayments and very little capital.
Consider the case of the $300,000 mortgage at 7.5 per cent. If you were to pay that off over 30 years making minimum repayments, your total payments would equal $755,000.
Over the first year you would have paid $25,200, with $22,400 of that being interest and only $2,700 being principal repayments. If you made the higher suggested home loans of $2,765, you would have paid another $8,000 off the mortgage - or more than quadrupled the amount of the loan you had repaid! To put it another way you would have reduced the loan to around $289,000, which would usually take until half way through your third year.
When you make extra repayments, the money you add to the loan effectively ?earns' you a rate of return of 7.5 per cent a year. This saving is tax free and interest free making it a very effective use of your money. This is far more effective than investing the money into a cash account earning only 6.5 per cent and then being taxed at 31.5 per cent as well.
Take your monthly repayment, halve it, and pay it every fortnight. (This way you make two extra fortnightly repayments per year)
Pay your income into your loan, live off a credit card, and then pay the credit card from the loan (this way your income is immediately reducing your interest payments in the loan - the downside of this scheme is the damage that redrawing from a home loan can cause, which we discuss later).
Fixed vs variable rate loans
According to the 'Rate City' website, the majority of US home loans consumers use fixed rate mortgages, and more than 85 per cent of New Zealand consumers have fixed rate loans. In Australia we have the majority of mortgages on variable rates.
I think that there is a case for a higher profile for fixed rate mortgages. Fixed rate mortgages remove the biggest risk of all - a sharp rise in interest rates and having to 'fire sale' your house into a falling market.
There are now fixed rate mortgages that do allow extra repayments, which gives the flexibility to have a fixed rate and still get ahead on the repayments.
Fixed rate mortgages provide some certainty as to what the repayments are over a set time period. Another solution worth considering is having some of the mortgage at a fixed rate and some at a variable rate.
The Dangers of Redrawing
A key danger of modern mortgages is that they allow people to redraw from the mortgage. The word equity has become part of modern household financial management.
There is a danger with this. The constant withdrawing of money from home loans mean that even though people have a key goal of owning their own home, they get further and further away from this.
At the extreme end of the market, people who get in the habit of revaluing their property, increasing their loan and redrawing the balance out of their loan can actually price themselves out of the market. Their loan grows and grows until high interest rates, unexpected costs or the loss of income means that they cannot afford to pay the mortgage any more and lose their house.