The light at the end of a 30-year mortgage tunnel is pretty dim, but it doesn’t necessarily have to be. Most home loans could be paid off significantly faster-saving thousands in interest, just by making a couple of changes to how your money moves around. Unfortunately, most bank managers will not be too forthcoming on telling you exactly how to do this. Why would they show you how to reduce their profits?
Maximising your cash flow may not be rocket science, but it does need to be structured correctly in order to avoid some of the dangers involved to make it work as hard as it possibly can. It’s based on putting your money in the account where it is either going to make the most interest or save the most interest. Typically, most people deposit their income into a transaction account which does not pay interest on the balance. While it is sitting there, the bank is in fact lending it out to other people who have home loans and credit cards and are collecting interest payments from them. So the bank is lending your money to other people and the bank is earning interest from them. How do they repay you for allowing them to do this? Well they certainly don’t share their profits with you if that was what you were expecting. Instead, they charge you account keeping and transaction fees. Talk about double-dipping! So where can you park your funds so that they earn you interest?
- High interest online savings accounts (currently paying you about 2% interest on your balance).
- Term Deposits. You can get slightly better interest rates in a term deposit but you don’t have easy access to the funds like you do in a savings account.
- If you want to withdraw the money before the term ends, then there could be big penalties for doing so.
With all of these types of interest bearing accounts, when you earn interest that interest is considered to be income and you will be taxed on it. So, for example if you are being taxed at 34% then your 2% online saver interest will actually only pay you about 1.4% after all the tax has been taken out. What’s the interest rate on your home loan? Most people are paying around 4% interest on their home loan, so earning 2% after tax earnings on your online saver becomes a false savings while you have to fork out 4% on the home loan. This is where you can often get the best return for your money.
By putting all your income and savings into your home loan, you are reducing the balance that the bank can charge you interest on. So even though you won’t be earning interest, you will be saving interest, and the government cannot tax us on interest that we save. That is why most people who are committed to reducing their debt as quickly as possible use their income and savings to reduce the balance of their home loans, which in turn reduces the amount of interest payable as well as the bank charges each month.
Making more than the minimum repayment is one way of reducing your home loan. Let’s say, if you had a loan of $250,000 with an interest rate of 5.0% over 30 years and made just $50 extra repayments per month, you would cut 2.5 years off your loan term saving you over $40,000 in interest. If you made extra repayments of $100 a month, this would cut 5 years off your loan and save you over $75,000 in interest.
Fortnightly or Weekly Repayments:
Making your mortgage repayments weekly or fortnightly can have a similar effect. When you pay monthly, you only make 12 payments per year, but when you pay weekly or fortnightly it works out to be the same as 13 monthly repayments so in effect you are making one extra payment per year. Also, by making your repayment soon after you receive your income, you are reducing the balance that the bank can charge you interest on. This means that the interest component of your repayment will be less and you would then be making a larger payment off the actual balance. It might be minuscule to start with, but over time the savings will grow. As Albert Einstein said, “the most powerful force in the universe is compound interest”.
All of Income Approach:
The most effective way to reduce your debt as quickly as possible involves using all of your income to reduce the balance that interest is calculated on. This usually involves having your earnings deposited directly into the home loan or into an offset account which is attached to the home loan. This means that from the minute you are paid, you are reducing the balance that the bank is allowed to charge you interest on. A Pandanus Finance Financial Specialist will show you exactly how the various accounts function, make you aware of the benefits and dangers of each type and discuss the emotional and psychological differences involved in operating them. We can then work out which system is going to suit your situation best and tailor the loan to your needs.
3 steps forward, 2 and a half steps back. That’s how most people struggling with credit cards and personal loans feel – you just never get anywhere and all your income goes straight to paying off interest to the bank. One of our major goals here at Pandanus is to help people take control of their finances. For a lot of people this is easier said than done. One fact remains the same though – interest is only good for the bank. If you can reduce the amount of interest you pay, then you should be able to make larger repayments off the actual loan. The more the loan itself reduces, the more the amount of interest payable reduces and the less you have to pay in interest and so on.
If you have numerous debts but do have some equity in your property, you may want to consider increasing your home loan to pay off the other debts. The home loan interest rate is usually the lowest, meaning for example that your credit card interest rate could drop from around 18% down to the home loan rate which could be less than 5%.