Pay off your home loan sooner
For many people, their biggest priority is to pay off their home loan as quickly as possible. It can provide a sense of freedom to actively reduce the amount you owe the bank, and know you own a bigger portion of your home. Here's an example of how one couple take a different approach so they can achieve this goal sooner.
Background
Carolyn and Ian have $300,000 left to pay on their home loan, and would like to pay this off as quickly as possible.
Carolyn and Ian's goals
They want to minimise their interest payments to the bank and be free of debt as soon as they can.
They also think they could be doing things more efficiently to make the most of their money now and in the future.
Carolyn and Ian meet with a financial adviser to see if they've made the right decisions in managing their finances.
Their adviser assesses their situation and suggests a number of smart strategies to make their debt work more effectively. While these strategies are fairly straightforward when used on their own, their true value comes into play when used collectively.
Consolidate debts
Strategy 1 — Consolidate debts to save money
If you have difficulty with budgeting and financial discipline, an adviser can help keep you on track and make the strategies work for you.
Carolyn and Ian's adviser suggests they increase their mortgage and use the extra cash to pay off their personal loan and credit cards.
By doing this they'll pay less interest, as the lower interest rate on their home loan will apply to all their debts.
However, it's important they keep making at least the same overall loan repayments. Otherwise, it could take them longer to pay off their combined debt, and they could end up paying more interest over the life of the loan (despite the lower interest rate).
What are the benefits?
With this strategy, Carolyn and Ian can:
- save on interest, and
- pay off their debts sooner.
How does it work?
Carolyn and Ian have a home worth $500,000 and the following debts:
| Debts | Outstanding balance |
Interest rate |
Current repayments (p/month) |
|---|---|---|---|
| Home loan (20 year term) | $300,000 | 7% | $2,326 |
| Personal loan (5 year term) | $10,000 | 12% | $222 |
| Credit cards | $5,000 | 17% | $66 |
| Total | $315,000 | $2,614 |
To save on interest, and use their debt more efficiently, they increase their home loan from $300,000 to $315,000 and use the additional $15,000 to pay off their personal loan and credit cards.
This means the home loan interest rate of 7% will apply to all their debts and the total minimum repayment will reduce to $2,442 – a cashflow saving of $172 in the first month alone.
But rather than spending this extra cash, they will continue to pay $2,614 into the consolidated loan each month until their home loan is paid off. This allows them to pay off their debts sooner and save $11,432 in interest.
| Separate loans¹ | Consolidated loan¹ | |
|---|---|---|
| Outstanding loan(s) | $315,000 | $315,000 |
| Monthly repayments | $2,614 | $2,614 |
| Remaining term | 17.8 years | 17.4 years |
| Total interest payments | $241,958 | $230,526 |
By using this strategy, Carolyn and Ian save $11,432 in interest.
1. In both options, we've assumed repayments of $2,614 are made for the life of the home loan. With the separate loans, payments are re-directed to the home loan once the personal loan is repaid.
Use emergency cash reserve
Strategy 2 — Use your emergency cash reserve more effectively
A redraw facility allows you to make extra payments directly into your home loan and withdraw the money again if necessary. There is often a minimum redraw amount and/or a fee for each withdrawal, but you can usually access the cash within 24 hours.
Talk to your financial institution to see if an offset account and redraw facility are available on your mortgage.
Carolyn has just received an after-tax bonus of $12,000, which she and Ian keep in a joint cash account.
They treat this money as an emergency cash reserve, in case of unexpected bills such as home repairs, illness or even an unplanned holiday. By using a cash account they'll have immediate access to their money, but it has limitations:
- The interest rate is much lower than what they pay on their home loan, and
- Every dollar they earn in interest is taxed at their marginal rate of 31.5%.
To use their emergency cash reserve more efficiently, their adviser suggests putting the money into a 100% offset account linked to their mortgage.
Not only will they have immediate access to their money, but they will achieve a better return, save interest and pay off their home loan sooner.
Note: They could gain the same benefits by transferring the money directly into their home loan, as long as it has a redraw facility.
What are the benefits?
By transferring their emergency cash into a 100% offset account, they'll effectively reduce the balance on which their home loan interest is calculated.
This means they'll 'earn' the rate of interest charged by their home loan, and won't need to pay tax on those earnings.
By maintaining their repayments, they'll pay more off their home loan and be debt-free sooner.
How does it work?
Carolyn and Ian's outstanding home loan is $315,000 after consolidating their debts, and the interest on the loan is 7% pa. Their emergency cash reserve of $12,000 is currently sitting in a bank account, earning just 4% pa.
As they both pay tax at a marginal rate of 31.5%1, the after-tax return on the bank account is 2.74%; much lower than the net return of 7% on their home loan.
They transfer the $12,000 into a 100% offset account which immediately reduces the size of their home loan for interest calculation purposes to $303,000.
Even though they're saving interest, Carolyn and Ian maintain their monthly repayments of $2,614. This reduces the principal further, as well as the term of their loan.
| Before strategy | After strategy | |
|---|---|---|
| Loan term | 17.4 years | 16.2 years |
| Total interest payments | $230,526 | $203,734 |
| Interest saving | $26,792 |
By using this strategy, Carolyn and Ian save $26,792 in interest payments and reduce the term of their home loan by 1.2 years.
1. Includes the Medicare levy of 1.5%.
Harness cashflow
Strategy 3 — Harness cashflow to reduce inefficient debt
Carolyn and Ian's adviser recognises they have spare cashflow at the end of each month and suggests using this additional cash to pay more off their home loan (which is $303,000 after implementing the first two strategies). This will save a considerable amount in interest.
How does it work?
Ian receives a fortnightly salary of $2,213 after tax, and Carolyn receives $1,823 after tax. They make monthly home loan payments of $2,614, and spend $4,800 on living expenses (excluding loan repayments) each month.
The interest on their home loan is calculated on the outstanding daily balance, even though it's only charged against the loan once a month. So, Carolyn and Ian can reduce their average daily loan balance and pay less interest by:
- Increasing the frequency of their payments from monthly to fortnightly (ie they will pay $1,206 each fortnight rather than $2,614 per month). This can reduce the average daily loan balance even though the annual repayments remain the same.
Note: These benefits only apply because Carolyn and Ian's salaries are paid more frequently than they make loan repayments. - Reducing their living expenses by $20 a fortnight, and using this extra cash to increase their loan repayments to $1,226.
- Crediting their entire salary into a 100% offset account and withdrawing money as required to meet their living expenses. As their salaries hit the loan account sooner it immediately reduces the size of the loan, which has the same effect as increasing both the repayment frequency and the regular repayments.
- Paying most of their living expenses (75%) with a credit card. They will then transfer money from the offset account to pay off the credit card within the interest-free period each month. This means they use the credit card provider's money to fund their living expenses, while using their own funds to reduce the average daily balance of their home loan.
The incremental advantage of adopting each of these strategies is:
| Loan term | Total interest payments | |
|---|---|---|
| Before strategy | 16.2 years | $203,734 |
| Changing payment frequency | 16.2 years | $202,939 |
| Increasing repayments by $20 each fortnight | 15.7 years | $196,035 |
| Salary crediting | 7.9 years | $94,672 |
| Credit cards | 7.7 years | $90,935 |
Note: Carolyn and Ian receive a pre-tax salary of $60,000 and $75,000 respectively.
By using these strategies, Carolyn and Ian's home loan term will reduce by 8.5 years and they will save $112,799 in interest payments.
While these strategies help Carolyn and Ian pay off their home loan sooner, their adviser also suggests using the equity in their home to build long-term wealth.
Read an example of how this strategy works
Note: This case study is for illustration only.