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Mortgage Reduction Strategies  

 

 

 

 

 

 

Mortgage Reduction Strategies

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The word Mortgage is actually a concatenation of two French words: the word Mort which means "death", and the word Gage which means "pledge". So in effect, a mortgage is a "death-pledge".

The banks will generally structure a home loan for a 25 or 30 year term. This allows them to maximise the interest payments they will receive from you. But it need not be this way.

Reducing the term, and the amount of interest you will pay over the life of your mortgage, is quite a straightforward process. By applying a few basic strategies, one can pay off one's home loan in half the mandated time or less, without making any additional repayments over and above those normally required. How is this possible?

The key principle of Mortgage Reduction is that "Interest is calculated on the daily balance". Therefore, the day-to-day balance of the mortgage account has a significant impact on the interest charged to the loan, and therefore the term of the loan.

 

There are four basic methods one can employ for Mortgage Reduction. You can use only one of these, or you can use a combination of several of these for maximum benefit. The first two do not require you to pay anymore than your standard repayment, and yet you can halve your loan period. If you don't use either method 1 or 2, then the third requires only a fractionally higher repayment, which you will hardly notice, and yet it will likely shave 6 years and $10's of thousands in interest off your home loan.

 

The 4 methods are:

  1. Use a 100% Offset Account

  2. Use a Home Equity Loan/Line of Credit

  3. Make Weekly or Fortnightly repayments instead of monthly

  4. Make extra payments when possible (i.e. tax return cheque / Christmas bonus)

 

The basis behind methods 1 and 2 is to restructure the funding of your property in order to minimise the interest which is charged to your loan.

 

If you're a little unfamiliar with the account types I mentioned for methods 1 and 2, see the article The Different Types of Home Loans.

 

Let's expand upon the 4 methods.

 

 

Method 1 - Use a 100% Offset Account:

 

The 100% Offset Account method, as well as Method 2 - Using a Home Equity Loan/Line of Credit, use the same principle.

Method 1 still requires you to make your monthly payment and your loan will thereby be reducing over time. Method 2, however, requires a certain amount of discipline and restraint, as you need only make the interest payments.

The principle both methods employ is to funnel all of your income and savings into a facility that will either:

 

i) "offset" or annul the interest which is charged against a portion of the balance of your loan (method 1); or
 

ii) directly reduce the loan balance upon which interest is calculated (method 2)

 

Most people deposit their money into an every day savings account to pay for living expenses, bills, and as a place to store savings. Banks usually only pay in the vicinity of .01% to 3% on such accounts, and you have to pay tax on that.

 

By putting your money in a 100% Offset account, you will be putting it where it can work the hardest for you by offsetting the interest on your mortgage - tax free!!

 

Let's use an example to best illustrate how a 100% Offset Account can slash years off your loan and save you $10's of thousands of dollars in bank interest.

 

Heath and Melissa are humble battlers.

    • They both work and have a combined weekly after-tax take home pay of $770 (or $3337 p/mth).

    • They have a $150K mortgage at 6.7% which they have taken out over 25 years.

    • Their mortgage payment is $1032 p/mth, and they share a car so they get by on $400 p/week (or $1734 p/mth) to cover all their living expenses.

They restructure their accounts in the following manner:

  1. Instead of having all their income go into a separate savings account, they open a no minimum amount, low/no fee 100% Offset account which they link to their home loan and organise for both their pay-cheques to go into the Offset account. Some providers require that you have a minimum balance of $2000 or so before they apply the Offset so beware and shop around (see: Conclusion).

  2. They also apply for a no fee credit card with a $2000 limit (enough to cover their $1734 p/mth living expenses), a minimum 30 day interest free period, and organise with their finance provider to automatically payout the monthly balance of the card from the funds in their offset account at the end of the interest free period. This is known as a "sweep" feature - it'll avoid you ever having to pay interest on the card balance as you won't need to remember to pay the card out at the due date every month.

  3. They then make most of their monthly purchases using the card instead of using cash.

 

By structuring their finances this way, they will be having their full combined net salaries of $3337 per month sitting in their offset account for the month until the credit card balance is paid out. This will be effectively reducing the balance of their home loan, upon which interest is calculated daily, by $3337 for the month.

 

So what difference does this then make over time? Well, assuming they set and monitor their budget so that they don't spend more than their $400 p/week allocated for living expenses, and assuming they pay all their bills via their credit card, the result will be that they will completely pay out their mortgage in 11yrs and 1mth (not 25 yrs), and will save nearly $100,000 in interest in the process.

 

Let's look at the stats:

 

 

Traditional P&I Loan

P & I Loan with Offset Account

Time To Repay Mortgage

25 years

11yrs 1mth

Total Interest Payments to the Bank

$159,547

$63,006

Total Principal Payments Made

$150,000

$74,250

Offset Account Balance

Not Applic.

$75,943*

Total Repayments Made

$309,547

$137,256 + $75,750 (Offset a/c bal.) = Total $213,006

Time Saved

Nil

13yrs 9mths

Interest Saved

Nil

$96,541

* Note: The $75,943 which has accrued in their offset account over 11yrs and 1mth time is calculated by multiplying $571 x 133mths (11yrs 1mth). They are paying their combined salaries of $3337 into this account monthly, and deducting $1032 for their mortgage payment, and $1734 for their monthly living expenses.

$3337 - ($1032+$1734) = $571 p/mth left to accrue in the offset account.

If you don't like credit cards and choose not to use one, that's fine - it'll just take a bit longer to amortise your loan. In the example provided, Heath and Melissa will still be miles ahead by using a 100% Offset account, even if they have to dip into their account during the month to cover expenses.

 

You should close all your other non-essential savings accounts and use the 100% Offset account to hold all your cash and to conduct all your transactions. You'll save on fees by not having multiple accounts, and the maximum balance possible will be working in your favour against the mortgage. Finally, make sure it is a TRUE 100% Offset and not one that pays a lower rate of interest to your mortgage - see the article The Different Types of Home Loans for more detail on this.

 

 

 

Method 2 - Use a Home Equity Loan/Line of Credit:

 

A Home Equity Loan, or Revolving Line of Credit as they are commonly referred to, applies the same principle as the 100% Offset account in that it enables every dollar of your income and savings to be used to reduce the mortgage interest.

 

However, it's probably fair to say that a Home Equity Loan is only suitable for people who maintain a budget and STICK to it. There are three important considerations with using a Home Equity Loan for mortgage reduction purposes versus using a 100% Offset account:

  1. Home Equity Loans are interest only loans and have no term, hence you are not constrained to ever pay it off

  2. Your credit limit is normally 80% of the value of your home, which could be hazardous for those who are tempted to stick their hand into the cookie jar for discretionary spending purposes!

  3. The interest rate on a Home Equity Loan is generally a little higher than for a standard variable rate loan, maybe 0.5% as an example

For those who are disciplined, a number of advantages apply to Home Equity Loans:

  1. You can consolidate other loans and credit cards which are on a higher rate of interest into the lower rate Home Equity loan

  2. They're generally portable, hence saving you on application fees and establishment costs should you move house in the future

  3. More aggressive or sophisticated home owners could use their equity to invest at a higher rate of return & use the returns to pay off the principal on the debt faster

See the section entitled Home Equity Loan/Line Of Credit in the article The Different Types of Home Loans for more detail on this type of loan.

 

Putting aside the features and flexibility of these loans as detailed in that article, the example we used for Heath and Melissa in Method 1 would yield essentially the same result if they had used a Home Equity Loan. They would still slash 14 years off their home loan and save nearly $100K in interest.

 

A final word: if you spend more than you earn, then this is definitely not the option for you. Stick to a 100% Offset account.

 

It's best to do a budget first and set a goal as to how much you want to have paid off the loan at the end of each year. Put dates on your plan and work out what the loan balance will have to be at the end of each month in order for you to get there. And finally, and most importantly, after setting up your Home Equity Loan, review your expenditure against your budget plan monthly.

 

 

Method 3 - Make Weekly/Fortnightly Payments instead of Monthly:

 

If you're unable to use a 100% Offset or Home Equity Loan for your Mortgage Reduction, and you are currently making monthly payments, then switch your payments to fortnightly or weekly.

 

There are two fundamental reasons why weekly or fortnightly is better.

  1. Because interest on loan accounts is calculated on the daily balance. As you'll be reducing the balance of the loan more than monthly, you're creating a slightly lower balance upon which the interest will be calculated. However, the advantage of doing this will be pretty minimal.

  2. The main benefit achieved using this method is because you will be tricking yourself into making an additional annual monthly repayment, and the advantage of doing this is quite significant.

You see, if you are making monthly payments, you will be making 12 payments every year. But if you make fortnightly payments, you will not be making 24 annual payments but 26.

 

However, for this method to be of benefit, you need to set your new fortnightly payment amount at exactly half your current monthly payment.

 

Beware: if you approach your bank manager and tell him you wish to switch from monthly repayments to fortnightly, he/she may use the following calculation: (Mthly Pmt x 12) / 26

 

If you use the bank's formula, there'll be virtually no benefit to you.

 

Taking the example of Heath and Melissa (see Method 1 above), the table below shows how many years the use of Method 3 will reduce off their mortgage.

 

 

P&I Loan with Monthly repayments

P&I Loan with Fortnightly repayments

Repayment Amount

$1032 p/mth

$516 p/fortnight

Time To Repay Mortgage

25 years

20yrs 8mths

Total Interest Payments to the Bank

$159,547

$127,600

Total Principal Payments Made

$150,000

$150,000

Total Repayments Made

$309,547

$277,608

Time Saved

Nil

4yrs 4mths

Interest Saved

Nil

$31,947

 

By simply paying 50% of their current monthly repayment fortnightly instead, they will save nearly $32,000 in interest and 4½ years off their loan.

 

Incidentally, this method proves to be far more effective in high interest rate times, and can slash many more years off your loan than with the current low rates we are experiencing at present.

 

 

Method 4 - Make Additional Payments When Possible:

 

When you begin paying off a mortgage, the first few year's payments are predominantly made up of interest. In fact, in the first 14 years of a 25 yr P&I loan, you'll be paying more interest with every payment you make than principal off the loan.

 

If you can pay a little extra to eat into the principal, then the difference can be significant.

 

Let's look again at Heath and Melissa. They may be unable to take advantage of Methods 1 and 2 at present, but have chosen to make use of Method 3. However, they would still like to clear their loan faster than the 20yrs 8mths we came up with in the last example.

 

Every year in August, they receive a combined tax refund for about $2000, and they have chosen to put this directly towards their home loan every year until the loan is paid out. The table below shows the difference this will make:

 

 

P&I Loan with Monthly repayments

P&I Loan, Fortnightly repayments + Annual ATO refund for $2000

Repayment Amount

$1032 p/mth

$516 p/fortnight + $2000 per annum

Time To Repay Mortgage

25 years

15yrs 10mths

Total Interest Payments to the Bank

$159,547

$93,130

Total Principal Payments Made

$150,000

$150,000

Total Repayments Made

$309,547

$243,130

Time Saved

Nil

9yrs 2mths

Interest Saved

Nil

$66,417

 

By combining methods 3 and 4, Heath and Melissa will now save $66,400 in interest and slash over 9 years off their loan.

 

 

Conclusion:

 

In conclusion, the most important element in all Mortgage Reduction strategies is YOU.

 

You can derive much benefit by using these methods, but you'll derive maximum benefit if you set targets, write out a plan and budget and monitor it monthly. Be discerning with your expenditure. We suggest using some budgeting software such as the Financial Advisor program as a basic example. This will also allow you to create and calculate your own mortgage amortisation schedule (as we have done for Heath & Melissa). Be disciplined - it'll be worth it.

 

Here are a few additional tips:

 

  • When restructuring your finances, spend the time to do some research on interest rates and fees across many lenders. Check out the smaller lenders - you may be concerned about their long-term viability, but remember that it's you that will have their money not the other way around!

  • Hidden charges, fees and restrictions usually counterbalance lower advertised interest rates: quite often the lowest interest rate is not the best or most efficient loan.

  • Speak to your lender about what financial packages they have on offer. By consolidating your banking with one provider, you may be able to get a fee free home loan, offset account, and credit card, as well as discounted home and car insurance. Over a period of years, ploughing the savings you make into your mortgage could make quite a difference.

  • If you think you might be moving, consider a "portable" home loan (such as most Home Equity Loans). You will thereby avoid some stamp duty, discharge costs and establishment fees when you move as you will be able to use the same loan.

  • If you are self-employed or run a business in your own name and are able to, temporarily park the business cashflow in your Offset account or Home Equity Loan until it is needed. This could reduce your loan interest significantly.

  • If you're a professional (teacher, dentist, etc..), look out for "professional" loan packages. You can get a discounted interest rate and bonuses just because the finance providers believe you have stable employment.

  • Make sure your finances are structured correctly. Some money spent on good financial advice could well be worth it. For example, if you have investment property in addition to your own home, it's usually best to put the investment property on an "interest only loan" and plough the saved principal repayments into your "principal and interest" home loan. The interest on an investment property is tax deductible whereas the interest on your own home is not. Do all you can to pay off your non-deductible home loan first, and then look at reducing your tax deductible loans. If you're in the top tax bracket, the difference over time can be quite significant.

 

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