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Bookmark This Article for Future Reference
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".
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:
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 restructure their accounts in the following manner:
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:
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:
For those who are disciplined, a number of advantages apply to Home Equity Loans:
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.
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.
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:
By combining methods 3 and 4, Heath and Melissa will now save $66,400 in interest and slash over 9 years off their loan.
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:
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This article is: © Copyright 2003-2010, Financially Free Pty Ltd. All rights reserved worldwide. Copying or reproduction is prohibited without prior permission.
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