Mortgage Reduction Strategies

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 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. This can be achieved even without making any additional repayments over and above those normally required, providing you have a modest amount of surplus income each month to save and offset against the loan balance. 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 any more than your standard repayment, and yet you can halve your loan period assuming you have a modest amount of disposable income to offset and accrue against the loan balance each month. 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 4 years and $10’s of thousands in interest off your home loan.

The 4 methods are:

Use a 100% Offset Account
Use a Home Equity Loan/Line of Credit
Make weekly or fortnightly repayments instead of monthly
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, refer to the article The Different Types of Home Loans. (coming soon)

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 degree 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:

Offset or annul the interest which is charged against a portion of the balance of your loan (method 1); or
Reduce the loan balance upon which interest is calculated (method 2).

Most people deposit their income into a basic transaction/chequing account to pay for living expenses, bills, and as a place to store savings. Banks pay minimal to no interest on such accounts, and any interest you do earn is taxable.

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 illustrate how a 100% Offset Account can slash years off your loan and save $100’s of thousands of dollars in bank interest.

Heath ($90K pa) and Melissa ($80K pa) are average middle class earners.

They have a combined weekly after-tax take home pay of $2,509 (or $10,872/mo).
They have a $550,000 mortgage at 6.77% which they have taken out over 25 years.
Their mortgage payment is $3,807/mo. They live frugally and share a car, so they get by on $1,100/wk (or $4,767/mo) to cover all their living expenses.

They restructure their accounts in the following manner:

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 $2,000 or so before they apply the Offset, so beware and shop around (see: Conclusion).
They also apply for a no fee credit card with a $10,000 limit (enough to cover their $4,767/mo 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.
They then make most of their monthly purchases using the credit card instead of using cash or a debit card.

By structuring their finances this way, they will be having their full combined net salaries of $10,872/mo sitting in their offset account for the month until the credit card balance is paid out. This will effectively reduce the balance of their home loan – upon which interest is calculated daily – by $10,872 for the month.

So, what difference does this make over time? Well, assuming they set and monitor their budget so that they don’t spend more than their $1,100/wk 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 10yrs and 7mths (instead of 25 yrs), and will save $371,824 in interest in the process.

Let’s look at the stats:

Traditional P&I Loan

P&I Loan with Offset Account

Amount Borrowed

$550,000

Time To Repay Mortgage

25 years

10yrs 7mths*

Interest Rate

6.77%

Monthly Principal & Interest Repayment

$3,807

Total Interest Payments

$592,089

$220,265

Total Principal Payments

$550,000

Offset Account Balance

Not Applic.

$289,548**

Total Repayments

$1,142,089

$480,717 + $289,548 (Offset a/c bal.) = Total $770,265

Time Saved

Nil

14yrs 5mths

Interest Saved

Nil

$371,824

*This assumes using the full offset account balance to clear the remaining mortgage balance at the 10yr 7mth mark. If the offset balance is kept in the offset account, it would take 16yrs and 10mths to clear the mortgage (most online calculators hosted by the banks apply this longer offset amortisation method). The interest saving is roughly the same, because the offset account balance would nullify the mortgage interest for the remaining 6yrs and 3mths. At the end of the 16yr 10mth term, they would have a $464,196 nest egg in their offset account. However, they would likely be earning no interest on the offset account balance once it exceeds the mortgage balance, so it would make better sense for them to simply clear the remaining mortgage balance at the 10yr 7mth mark with the funds in the offset account.

**The $289,548 which has accrued in their offset account over 10yrs and 6mths is calculated by multiplying $2,298 x 126mths (10yrs 6mths), and $1,035 for the final month’s payment. They are paying their combined net salaries of $10,872 into this account monthly, and deducting $3,807 for their mortgage payment and $4,767 for their monthly living expenses. $10,872 – ($3,807+$4,767) = $2,298/mo left to accrue in the offset account.

If you don’t like credit cards and choose not to use one, that’s fine. It won’t make much difference in the time it will take amortise the mortgage. 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:

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

You can consolidate other loans and credit cards which are on a higher rate of interest into the lower rate Home Equity loan;
They’re generally portable, hence saving you on application fees and establishment costs should you move house in the future;
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 over 14 years off their home loan and save $371K in interest.

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. There are plenty of good online calculators to help you. Just do a search for “mortgage amortisation schedule calculator”. 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 consider switching your payments to fortnightly (known as bi-weekly in North America) or weekly.

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

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.
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 more 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

Amount Borrowed

$550,000

Interest Rate

6.77%

Monthly Principal & Interest Repayment

$3,807

$1,903.50/fortnight (bi-weekly)

Time to Repay Mortgage

25 years

20yrs 8mths

Total Interest Payments

$592,089

$471,700

Total Principal Payments

$550,000

Total Repayments

$1,142,089

$1,021,700

Time Saved

Nil

4yrs 4mths

Interest Saved

Nil

$120,389

By simply paying 50% of their current monthly repayment fortnightly instead, they will save over $120K in interest and shave over 4 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 today.

Method 4 – Make Additional Payments When Possible

When you begin paying off a mortgage, the first few years’ 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 each 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 of about $4,000, 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 $4K refund

Amount Borrowed

$550,000

Interest Rate

6.77%

Monthly Principal & Interest Repayment

$3,807

$1,903.50/fortnight (bi-weekly) + $4,000 per annum

Time to Repay Mortgage

25 years

17yrs 6mths

Total Interest Payments

$592,089

$387,849

Total Principal Payments

$550,000

Total Repayments

$1,142,089

$937,849

Time Saved

Nil

7yrs 6mths

Interest Saved

Nil

$204,240

By combining methods 3 and 4, Heath and Melissa will now save $204,240 in interest and slash 7½ 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, spreadsheet a plan and budget, and track/update it once a month. Be discerning with your expenditure – discipline usually pays big dividends.

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, including credit unions.
Hidden charges, fees and restrictions usually counterbalance lower advertised interest rates: 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. Invest some time into doing your own financial research or consider spending some money on good financial advice from an independent accountant or financial planner. 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.

You are now armed with sufficient information to get the ball rolling on your own accelerated mortgage reduction plan. Why not start today? Best wishes on your journey to becoming Financially Free sooner. 🙂