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Mortgages 2

 

Types of Mortgages

There are a few different types of mortgages and the most common is a principal and interest loan. With a principal and interest loan you have minimum repayments due each fortnight or month which is made up of part interest, part principal (the amount you originally borrowed). In the early years most of the repayment is interest. For example you have a loan of $500,000 at 7.5% interest over 25 years. Your monthly repayments are $3,695. Your first repayment is made up of $3,125 in interest and $570 in principal. At the end of the first month you owe $500,000 minus the $570 you have paid off the loan: $499,430. Your next repayment of $3,695 is made up of $3,121 in interest and $574 in principal. The reason for the changes in the interest and principal components is because the interest you pay is based on the remaining principal you owe.

Any extra repayments over the minimum should reduce the principal amount (a few low interest rate loans and fixed rate loans don’t allow extra repayments – make sure you check) but the actual set required repayments will be the same as long as interest rates remain steady. You can usually access any extra repayments you choose to make but there will be restrictions and fees for doing so. Principal and interest loans are the most basic loans around and should have the lowest interest rates when compared to other types of mortgages.

If you decide not to make any extra repayments, using the example of the $500,000 loan over 25 years we just looked at, it would take you 14 years to pay off the first third of principal, seven years for the next third and four years for the last third.

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FURTHER READING: Money lift-out in Wednesday’s Sydney Morning Herald and The Age: Great source of up to date, easy to understand information. The same articles are available online if you don’t like newspaper print on your fingers.

A different type of mortgage is a loan with an offset facility. This is a principal and interest loan linked to a savings account that you have with the same bank, where the amount in your savings is used as a credit to reduce the principal of the loan. E.g. If your loan is for $300,000 and you have $35,000 in a savings account, the interest payable is based on a loan of $265,000. These loans have a higher interest rate than a basic principal and interest loan and are a very good option for people who can save well.

Another type of mortgage is a line of credit. These loans are a bit like a credit card. Having read the general bagging that I have given credit cards in the earlier sub-topic, you may think I’m opposed to the idea of a line of credit. Not at all. Claudia and I have one. Just as a credit card can be a valuable tool for your finances, a line of credit can be the best loan type when used wisely.

A line of credit has a limit you can go up to at any time without extra fees or credit checks. Interest is charged to your account every month but there are no fixed dollar repayments because these loans are designed so that all your income goes into the mortgage (you don’t have a separate savings account). The line of credit has a higher interest rate than a loan with an offset facility and is very flexible but definitely not for people who are not disciplined with their savings. The lenders have been pushing this type of product over recent years because of the higher interest rates associated with them. It also does the banks no harm to offer a product where it is possible for the borrower to indefinitely remain in debt. If you can’t use a credit card without paying interest on it, there is no way you should even consider getting a line of credit.

The last type of loan we’ll look at is an interest only loan. These used to be only available to property investors, but their popularity among owner-occupiers has increased in recent years. With an interest only loan your payments are just that – interest, with no repayment of any principal. The attraction is that they have lower payments than any of the other loan types. A loan of $500,000 at interest rates of 7.5% would have payments of $3,125 each and every month. They do have lower payments but you don’t get ahead. Ever. At the end of the loan term, which for interest only loans is usually a maximum of five years, you still owe the bank half a million dollars. As they were originally designed for investors seeking tax deductions from interest payments, they should only be used by investors. (Did you notice I used the word “payments” rather than “repayments” in that paragraph?)

If you reckon your bank is doing its best to rip you off with your mortgage, or you want to change the type of mortgage you have, you better be prepared for some hefty fees, particularly if your interest rate is fixed. For more, read the CANSTAR Home Loan Fees article. It’s on the CANSTAR website where you can also compare interest rates on home loans, credit cards and savings accounts. (As of July 1 2011, laws were introduced to abolish exit fees from new mortgages. However, if your mortgage started before that date you may still be hit with the old fees.)

 

How to pay it off

Once you have a mortgage, what is the best way of paying it off? You should be paying as much off the loan as you can, as often as you can. When you are first looking at loans and how much you can borrow, you will probably sit down with someone who takes you through different scenarios with a loan calculator and works out how much you can borrow, and, based on current interest rates, what the monthly repayments will be over a period of 25 years. Then they will cut the monthly repayment in half and calculate the loan with fortnightly repayments. Suddenly, like magic, the loan is reduced to around 20 years and you have saved yourself tens of thousands of dollars in interest. How does this happen? Let’s look at an example.

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If you are fortunate enough to receive a bonus from work it’s a natural reaction to want to go and spend it all on a splurge at the shops. If you buy a whole lot of new clothes with this bonus, everyone wins except you. Your boss wins because you’ve blown your extra money and still need to do more overtime. The shopkeeper wins ‘cause they have the bonus in their pocket, and the bank wins as you will now be paying more to them for your existing debt. The best thing to do is to spend it on yourself by getting rid of more of your debt.

A lot of couples who both work decide to live off one income while the other income goes straight into the mortgage. Great idea, not just for those with a mortgage but also for those who will one day get a mortgage. A $40,000 wage saved for 5 years is more than $200,000 of deposit.

There are plenty of online mortgage calculators around for you to put personal figures into. This home loan calculator differs from most in that it gives a breakdown of month to month interest and principal payments and the overall amount spent on a mortgage over the entire life of the loan. If you would like to see how it would look if you put in extra regular or once off mortgage repayment figures, check out this extra repayments calculator.

Even if you don’t have a mortgage, play around with one of these calculators because the key to the repayment of a mortgage is the same as with other loans. Add in extra repayments to see thousands of bucks and many years slashed off your loan – compound interest at its most powerful.

Total repayments on $300,000 loan over 25, 40 & 50 year periods*

6% 7% 8% 9%
25 years $580,000 $636,000 $895,000 $755,000
30 years $648,000 $719,000 $792,000 $869,000
40 years $792,000 $895,000 $1,001,000 $1,111,000
50 years $947,000 $1,083,000 $1,222,000 $1,365,000

*Assumes no extra repayments and includes the principal amount.

The table above illustrates how much more a longer loan term will cost you, than a shorter loan term. Longer loans of 40 or 50 years are emerging onto the home mortgage market with the sales pitch of having lower monthly or fortnightly repayments. They do, but the same principle applies here – the longer you have a loan for, the more it will cost you and the happier the CEO of your bank will be. That’s exactly why I use 25 years as the default example when referring to example mortgages. Twenty five years used to be the standard, now 30 years is the standard. Compare the 25 and 30 year columns above and you see instantly why banks want to try to change the mindset of people into paying back a loan over a longer period.

A mortgage broker is someone who has knowledge on many different mortgages and can arrange one for you. They include groups like the Aussie Mortgage Market and Mortgage Choice. You can consider using a mortgage broker to find a suitable loan for you as they will probably find a better loan than you would have the patience to find yourself. Mortgage brokers do not have all the different loans from all available lenders on the lists they recommend on. But you can be assured that the brokers from Aussie Mortgage Market have all the loans available from Aussie Home Loans, as well as loans from most major lenders.

Mortgage brokers are usually paid by the lender you eventually decide to go with, and should be no extra cost to you. They may also be under an incentive to find you a loan that works so well for you that you will still have that loan in a number of years, at which time the broker receives a bonus payment. But most mortgage brokers are inclined to recommend to borrowers the products from which they receive the highest commissions. Some of those commissions may increase the more you borrow. E.g. The upfront bonus commission on loan amounts up to a value of $1 million may be 0.1% with that commission rising to 0.2% for amounts over $1 million, meaning brokers may have an incentive to get you to borrow more. So be aware that although a mortgage broker may be no extra cost to you, they may not be independent, unbiased and acting in your best interest. 

There is also a high chance that mortgage brokers will not have online home loans or loans from many mutuals (credit unions and building societies) on their list of recommended products. Online mortgages and mutuals often have lower interest rates than traditional ones, and one of the things that allows lenders to keep the rates for these loans lower is that they rarely pay commissions to brokers. I know that finding a mortgage can be frustrating with the amount of choice in lenders and individual products available, so you may find that you are happy negotiating a good deal with your current financial institution. This is especially relevant for those who already have mortgages but are looking for a better interest rate and more flexibility.

With interest rates you should factor in a rate rise of at least 2-3%. If you make repayments as though interest rates were already this high, when rates do rise, you won’t notice. If you have been keeping an eye on interest rate movements over the last couple of years you would have noticed they have remained at a record low for a while, and I am often asked when rates will change. The simple answer is, as I am not on the board of the Reserve Bank, I am not privy to their discussions and therefore how the hell should I know? In fact, as the RBA make interest rate decisions based on the most up to date economic data, most of their board members wouldn’t know for certain where rates will be two months from now.

A photo fo the reserve bank of australia sydney head quarters

The best way to look at interest rates is to look at a worst case scenario. If you have a mortgage or other large loan, always consider that rates will go up and cost you more. If you have money in a savings account, always consider that rates are on the way down and will earn you less. I am NOT saying the best thing to do is to fix your rate. Just please make sure that it comes as no surprise when interest rates head in the direction you didn’t want them to.

No matter what sort of debt you have, whether it’s a mortgage, personal loan, credit card, etc. if your interest rate is variable (as opposed to fixed), any rise in official interest rates will mean you will pay more for your loan. Your lender does not need to contact you before putting your interest rate up.

If you have the option, you need to decide whether to fix the interest rate you are paying on a loan at a specified rate and for a set time, or pay a variable interest rate. This option is most commonly available with mortgages and investment loans, and there are advantages and disadvantages to both scenarios.

Fixed Vs Variable Interest Rates

Variable Rates Fixed Rates
Almost always lower than current fixed rates Almost always higher than current variable rates
Can rise at any time Stay level for a set period
Can fall at any time Will not fall
Usually allow extra repayments May not allow extra repayments
Repayments are difficult to budget accurately Budgets can be accurately planned with steady repayments
Any early repayment fees are usually comparatively low May have significant fees for early repayment
Pre-payment of interest on investment loans is not possible Investment loans can be pre-paid (and tax deducted) 12 months or more in advance

You may have the option to split your loan and have part of it variable and part fixed. This way you get the advantages (and disadvantages) of both. The fact is that it is possible to save lots of money with either fixed or variable rate loans and it’s also possible to lose out with either. It is generally not financially viable to change your current variable loan to part fixed/part variable if you want to fix less than 50% of your loan, or if your total loan is under $150,000, as the costs of fixing will likely outweigh any advantages.

Confused? I never come across independent information that shows you are better off financially from fixing a mortgage. Many banks promote their fixed interest rates in a bombardment of advertising just after variable interest rates have risen (and most likely, the bank has already adjusted their fixed rates upwards well before the rise based on what the economic data is telling their forecasters). Ask yourself this: is the bank pushing the product that they receive more money from, in the interests of the customer or the interests of the bank?

Because interest rates will usually only rise when the economy is doing well, you would like to think that you would be getting decent pay rises as business booms, meaning that you can afford the higher interest repayments.

Minimum Monthly Repayments over 25 Years ($) at Various Interest Rates

Loan amount 5.00% 5.50% 6.00% 6.50% 7.00% 7.50% 8.00% 8.50% 9.00% 9.50% 10.00%
100,000 585 614 644 675 707 739 772 805 839 874 909
200,000 1,169 1,228 1,289 1,350 1,414 1,478 1,544 1,610 1,678 1,747 1,817
300,000 1,754 1,842 1,933 2,026 2,120 2,217 2,315 2,416 2,518 2,621 2,726
400,000 2,338 2,456 2,577 2,701 2,827 2,956 3,087 3,221 3,357 3,495 3,635
500,000 2,923 3,070 3,222 3,376 3,534 3,695 3,859 4,026 4,196 4,368 4,544
600,000 3,508 3,685 3,866 4,051 4,241 4,434 4,631 4,831 5,035 5,242 5,452
700,000 4,092 4,299 4,510 4,726 4,947 5,173 5,403 5,637 5,874 6,116 6,361

This table shows the monthly repayments for various mortgage amounts based on interest rates between 5% and 10%. It illustrates the increase of the repayments in dollar terms if interest rates rise. If interest rates drop and you have a home loan, try to keep your repayments at the level they were before the fall in interest so you get rid of your debt faster.

To sum up mortgages: borrow as little as possible and pay off as much as you can over the minimum requirements, as often as you can. This should see your mortgage paid off in the shortest possible time.

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