Wikipedia states that the word ‘mortgage’ comes from an old French term and means “death pledge”, with the pledge ending (dying) when either the obligation is fulfilled, or the property is taken through foreclosure. (Source 1)
This is a bit scary and in reality, getting a mortgage is pretty scary too! When you take out a mortgage, you are entering into a relationship with your bank, usually for 30 years. The average marriage length in Australia is only 12.3 years (Source 2), meaning that for some people their relationship with their bank might be longer than their marriage!
Making sure you have the right home loan in place is really important because having the wrong loan in place can end up costing you tens of thousands of dollars in additional costs or interest that didn’t need to be paid during your “death pledge” with the bank.
In this article we are going to outline five key elements you should know about before you consider your loan options with a bank. These topics will hopefully help you be more informed and prepared when you start thinking about what sort of home loan is right for you and your financial strategy.
1. Borrowing capacity
Your borrowing capacity is the amount of money you can borrow from the bank. This amount will be your guide from a property selection point of view when looking to purchase a home or investment property. It will also impact your ability to increase your existing mortgage (if you have one) to consider things like home improvements, renovations or accessing extra funds for investment purposes such as buying shares or obtaining funds for a deposit on an investment property purchase.
Your borrowing capacity will be determined by the income you earn, the amount of debts you have, your family situation (how many kids you have) and also what your monthly living expenses are. Another factor that helps determine how much money you can borrow from the bank is what mortgage interest rates are at the time you borrow. The lower interest rates are, the more you can borrow from the bank.
We use the below income guides as very rough estimate on what a client’s borrowing capacity may be when they are looking to borrow:
- 5-6 times your income to purchase a home
- 6-7 times your income to purchase an investment property
These amounts are guides only and a mortgage broker or bank will give you an accurate borrowing capacity based on your personal and financial situation.
When running your numbers and working out how much you should actually borrow from the bank, I would suggest that you look at what you can afford to pay in mortgage repayments each month and use that to determine how much you should borrow. This may differ to how much money the bank will lend you – your maximum borrowing capacity. It is likely that the amount the bank is willing to lend you, is going to be a much bigger figure than you will come up with after reviewing your monthly repayment capacity.
2. Loan Types
There are two main loan types that you can choose from when working out which loan option is the right one for you. These loan types include:
- Principal & Interest Home Loan
These loans have traditionally been for home loans on properties that people intend to live in. With this type of loan, a small part of every mortgage repayment you make goes towards paying back the money you borrowed from the bank.
With a principal and interest home loan you pay your loan down to zero over the life of your loan – which is usually over 30 years.
- Interest Only Loan
These loans have traditionally been for home loans for investment property purchases. With this type of loan, you only ever pay the bank interest on the amount of money you borrow and don’t actually pay back any of the funds you borrowed. For example, if you borrow $600,000 in 2020 then in 2030 you will still owe the bank $600,000.
Now why would people want to do this? Because interest repayments on investment properties are tax deductible whereas principal repayments on investment properties are not tax deductible. So if you have any non-deductible debt (debt you can’t claim a tax deduction on) like a mortgage on your home, credit card, HECS debt or personal loan, it is usually better to focus on paying these debts off first rather than your tax deductible debt. If you don’t have any non-deductible debts, then you may consider getting a principal and interest loan for your investment property purchase.
Since 2018 banks have tried to move as many clients as possible to principal and interest loans, so that they are paying down their loans with each repayment. To entice everyone to do this, they offer discounted rates for principal and interest loans vs interest only loans. Sometimes these discounts can be as high as 0.5% which on a couple of hundred thousand dollar mortgage can add up to a lot of money over the life of the loan.
3. Interest Rates
Once you have worked out how much you can borrow and what type of loan you will have. The next step is to consider what sort of interest rate option you are going to put in place. There are two interest rate options to consider and these interest rate options include:
- Variable Interest Rate
A variable interest rate is one that will either increase or decrease over time with the Reserve Bank of Australia’s (RBA) official cash rate.
If you took out a variable interest rate loan for a home purchase, at the time of writing this article (August 2020), the rate you may have is 2.8% per annum. If over the next two years the RBA raises Australia’s cash rate by 2%, this is likely to lead to a 2% increase in the variable interest rate charged by your bank – making your new interest rate 4.8% per annum.
This obviously means that you will have to pay more each month in repayments. This sort of increase on a $850,000 principal and interest loan will mean that your repayments go from $3,518/month (2.8% interest rate) to $4,485/month (4.8% interest rate) – an increase of $967 per month.
- Fixed Interest Rate
A fixed interest rate is as it sounds, one that is fixed at a certain interest rate for a specific period of time. These fixed rate terms usually range between 1 to 5 years and allow you to lock in your interest rate and repayment amount for that term.
What this gives you is certainty of what your repayments will be for the fixed rate period meaning any increases in the RBA cash rate won’t impact your repayments during your fixed rate term.
Using the above example, if you put in place a fixed rate loan of 2.8% on your $850,000 loan for 3 years, during that period of time your repayment would remain at $3,518/month – regardless of the RBA’s cash rate increases.
This option may be suitable if you are concerned about rates increasing in the future and the negative impact of this on your monthly cash flow position.
It also allows you to do some forward planning if there are changes occurring to your situation in the next couple of years that may change your household income and monthly cash flow. Gaining certainty by locking in your interest rate and repayment amount, could be advantageous when things like having a baby and losing one income for a period of time, starting a business, taking time off to travel (in a post covid world) or looking to do some study are going on in your life.
One thing to think about with fixed rate home loans is that they don’t offer much flexibility if your goal is to pay a lot off your loan each year in extra repayments. With a lot of banks only allowing you to pay an extra $10,000 per annum off a fixed rate home loan.
4. Loan Product
Banks have a number of different loan products that you can choose from when taking out a mortgage with them. Below, we are going to focus on what we believe are the two main loan products to consider when deciding which loan is right for you.
- Simple Home Loan
A simple home loan is also known as a basic home loan. It is for people who want a no-frills home loan with no or very low ongoing costs. Usually the only feature that this sort of loan includes is a redraw facility.
A redraw facility gives you the ability to make extra repayments on your home loan to help lower your balance and the interest that you pay to the bank. This gives you the ability to pull your money back out of your loan that you have paid over and above your minimum repayment. Many people use this as an extra bank account. They pay extra on their home loan each month and know that if they need this money for something in the future, they can pull it back out of their loan.
- Offset Account Home Loan
An offset account home loan is when you have a fully functional bank account linked to your mortgage that you can use to offset the interest you pay to the bank on your loan repayments each month.
For example, let’s say your mortgage balance is $850,000 and you have an offset account with $50,000 in it, when your mortgage repayments are due the bank will only charge you interest on the difference between your loan balance and the balance of your offset account – which in the above example would be $800,000.
The more money you have in your offset account each month, the less interest you are going to pay on your loan. These interest savings can add up to tens of thousands of dollars over time. This money is not locked away anywhere and is available in a bank account that can be used at any time.
These accounts can be great to direct your salary into each month, hold your savings and extra repayments on a property that you are living in now but would like to turn into an investment property one day.
One thing to note with these accounts is that banks don’t usually offer them for free. They usually charge clients an annual fee of anywhere between $200 to $400 per annum to have one of these accounts linked to their home loan.
At a cost of $300 per annum over 30 years the cost of this account could be approx. $9,000 ($300 x 30). So, if you decide to proceed with this loan option, you want to make sure you have a strategy in place to use your offset account and make the most of the interest savings available with these accounts.
Most principal and interest loan terms are for 30 years and banks would love if everyone waited 30 years to pay off their loans. This is because banks are in the business of making money and they make lots of money by lending us money to buy property. The interest they charge on the money we borrow from them is where most of the billion dollar profits they make each year, come from.
Therefore, banks will only ever look to charge you the minimum repayment amount on your mortgage each month and if that is all you ever pay it will be costly.
An $850,000 mortgage with an interest rate of 2.80% pa has a minimum monthly repayment of $3,518 per month. If you only ever pay the bank back the minimum repayment amount, then over the life of the loan (30 years) you will end up paying the bank back $1,266,254 – which is an additional $416,254 in interest on top of the $850,000 you originally borrowed from them.
A lot of people know about the numbers outlined above but often they don’t do anything about it. They accept what the bank charges them each month in repayments and are happy to only pay the minimum repayment amount as this means they have money to spend on other things that provide a bit more short-term gratification. As we have shown above this decision can prove to be an extremely expensive one over time.
But it doesn’t have to be this way, as there is an easy way to reduce the amount of interest you need to pay the bank back over the life of your loan. It’s probably the simplest financial strategy there is but it is also one of the most effective. The strategy is to pay more than the minimum repayment amount on your mortgage each month.
As you will see below it doesn’t take a lot of extra money to be paid onto your loan to make a significant difference to the amount you need to pay the bank back over time.
Using the $850,000 example we outline below how a few hundred dollars in extra repayments each month can lead to a significant financial saving for you over time:
- Extra $100 per month repayment
- Total monthly repayment – $3,618/month
- Total loan repayments till loan is paid off – $1,246,499
- Interest saving vs minimum repayment example – $19,755
- Years until loan is paid off – 28 years & 9 months (reduction of 1 year & 3 months vs minimum repayment example).
- Extra $250 per month repayment
- Total monthly repayment – $3,768/month
- Total loan repayments till loan is paid off – $1,220,256
- Interest saving vs minimum repayment example – $45,998
- Years until loan is paid off – 27 years (reduction of 3 years vs minimum repayment example).
- Extra $500 per month repayment
- Total monthly repayment – $4,018/month
- Total loan repayments till loan is paid off – $1,183,659
- Interest saving vs minimum repayment example – $82,595
- Years until loan is paid off – 24 years & 7 months (reduction of 5 years & 5 months vs minimum repayment example).
- Extra $1,000 per month repayment
- Total monthly repayment – $4,518/month
- Total loan repayments till loan is paid off – $1,128,951
- Interest saving vs minimum repayment example – $137,303
- Years until loan is paid off – 20 years & 10 months (reduction of 9 years & 2 months vs minimum repayment example).
Hopefully the examples above show you that no matter how much extra money you have available in your budget each month, by allocating a portion of that to your loan via extra mortgage repayments, it can make a significant financial difference to you over time. That money in saved interest repayments is much better in your pocket than the banks!
Getting the right loan and having the correct debt structure in place is such an important decision and crucial to any successful long-term financial strategy. We always suggest clients get the help of a good mortgage broker to assist with the loan process, to ensure that they end up with the right loan for their situation.
A good broker will take you through the process from start to finish and guide you through all the points we have outlined above. Which can save you a lot of time and help you avoid making any big financial mistakes.
We hope our home loan education blog has been useful and given you some insight into the key things you need to consider when entering a “death pledge” with a bank.
There is a lot you can do to ensure your mortgage with your bank is as financially advantageous for you as possible….this can also help ensure that your marriage outlasts your relationship with your bank!
Ryan Porter is a Wealth Coach at Catalyst Wealth Group. His mission is to help his clients achieve financial success and live their ideal life.
Any advice or information in this publication is of a general nature only and has not taken into account your personal circumstances, needs or objectives. Because of that, before acting on the advice, you should consider its appropriateness to you, having regard to your objectives, financial situation or needs.