Do you have ‘pay off home loan early’ on your to do list?
We’ve all heard that classic saying about putting aside a few dollars for a rainy day. But adding a little extra to your mortgage repayments, or even refinancing your home, could save you thousands of dollars in the long run.
The ABCs of mortgage interest rates
Your home mortgage repayments are made up of two parts – principal and interest.
The principal is the money you borrow to pay for the home you buy. You reach this amount by adding your costs, including stamp duty, to the purchase price and subtracting your deposit.
Let’s say you need $500,000, all together, to purchase the house of your dreams. So, you go to your mortgage broker and organise a loan for this amount – that $500,000 is called your ‘principal’.
But the bank isn’t going to loan you money for free. They will charge a fee for loaning you the money. This is the interest portion of your loan. It’s calculated as a percentage of the principal you borrow.
The interest rate charged by your bank is calculated daily and influenced by a number of factors.
Most importantly, it’s influenced by the rate charged by the Reserve Bank of Australia (RBA) for inter-bank loans. This is called the RBA cash rate target.
We’ve all seen those newspaper headlines on the first Tuesday of every month announcing whether the RBA has decided to lower, raise or keep its cash rate target steady.
The banks usually adjust the interest rates they charge in accordance with the RBA’s decision. How this impacts your mortgage depends on whether your home loan has a variable or fixed interest rate.
A variable interest rate means the interest rate you pay will move up or down in accordance with how your bank reacts to the RBA’s cash rate announcement. But if you’ve fixed your mortgage, the interest rate you pay will remain constant over the predetermined period, which is usually one to five years.
With us so far? Great, let’s delve in a bit deeper.
Invest or repay?
Say you just got a promotion at work and your salary has jumped by 20%. Some people say it’s better to save or invest those extra dollars, rather than to ‘pay off home loan early’.
Also, consider refinancing your home, which can save you a lot of money if you find a lower interest rate than you’re currently paying.
See your finance broker to work out the best plan for your situation.
Pay off home loan early – should you?
Because mortgage interest payments are calculated daily on the amount of principal you owe, every dollar paid above the required minimum goes towards reducing the size of your loan. Those extra repayments will shorten the time it takes to pay off your mortgage. This will reduce your interest paid and save you money.
You should be aware that in some circumstances, your plan to ‘pay off home loan early’ may trigger a financial penalty.
Most variable rate home loans give you the option of making extra repayments up to a limit, but if you’re on a fixed interest rate, they may trigger what’s called a ‘break fee’. This is a financial penalty the bank imposes because you’ve broken your the terms of your loan agreement.
Before you decide whether to make extra repayments on your home loan, consult your mortgage broker to find out whether this strategy will help or hurt.
Fortnightly instead of monthly?
The simplest way to pay extra off your home loan is by shifting your repayment schedule from monthly to fortnightly. A monthly schedule translates into 12 payments per year. But on a fortnightly schedule you’ll be making year 26 payments over the year.
This is the equivalent of 13 monthly payments over the year instead of 12. Those extra repayments over the life of your loan will make a big dent in the total amount you owe.
Periodic repayments or an offset account?
Let’s say you inherit a sum of money. Would it be better to make a lump sum payment to reduce your loan, refinance your home loan (even if it breaks the terms of your loan agreement), or use that money to repay your home loan a little extra every fortnight?
One solution might be placing your new windfall into a mortgage offset account. This is a transactional savings account linked to your mortgage.
The funds you deposit in your offset account are deducted against the amount you owe on your mortgage principal. Because the interest owed on your mortgage principal is calculated by the bank on a daily basis, every dollar you hold in your offset account is counted against your loan principal for that day.
This offset calculation reduces the amount you owe on your mortgage principal that, in turn, lowers the amount of interest you pay. But the money in your offset account is always available for withdrawal, just like a regular account.
Let’s illustrate this with an example.
You have a home loan of $500,000, and keep a balance of $75,000 in an offset account (with the same bank).
The $75,000 would be offset against the principle of your linked mortgage.
This means you’ll only be paying interest on $425,000 of your loan.
This could save you thousands of dollars over the term of your mortgage.
Just make sure your savings on interest payments will be larger than the fees you’ll pay for your offset account.
Refinancing your home loan
You may not have considered refinancing your home loan, but this can be a clever way to lower your interest rate and reduce your monthly repayments.
A new loan agreement for a lower interest rate can work wonders for your monthly cash flow. It will also leave you with more money for extra mortgage repayments that will reduce the principal of your home loan over time.
Some banks offer cashback bonuses to homeowners who refinance their home loans with those same mortgage lenders.
But remember it’s not always straightforward when it comes to refinancing your home.
If you have a fixed-rate home loan, you would have signed a contract to stay in the agreed arrangement for a specific period of time. If you break this agreement, you will have to pay a break fee and this can be expensive.
So, before you agree to any changes in your current loan, seek advice from your mortgage broker to ensure you’re getting the best deal for you.
How much could you save by refinancing?
Let’s go back to your $500,000 mortgage with a 30-year term at a 2% interest rate.
In this scenario, you’d be making monthly payments of $1,848, which would total $165,318 in interest payments over the life of your loan.
In other words, if you repaid the minimum required payments each month, you’d end up paying a grand total of $665,318 for your mortgage over those 30 years.
But if you added an extra $100 to those monthly repayments, you’d save $12,302 in interest charges and reduce the term of your loan by 25 months.