After seeing the option of reverse mortgages being mentioned in the papers too frequently as an option for 'asset rich retirees who are income poor', I just have to put my thoughts out there for those who are investigating reverse mortgage as an option.
Don't take out a reverse mortgage if you can avoid it.
You have probably spent the past twenty to thirty years paying off your mortgage where the first ten to twenty years was all interest payment and barely any principle. Do you really want the amortisation to work against you again in the last decades of your life when you should be enjoying life?
With reverse mortgages, there are no repayments, loan interest is added onto the principal amount borrowed to be paid off when the property is sold. The debt will grow fast. It will be interest debt compounded with interest charged on interest.
Compound interest works in your favour when you put your savings in the bank. Interest charges compounded year after year will destroy the equity in your home when it's left to accumulate in the typical reverse mortgage structure.
Ever heard of a loan amortisation schedule? I really recommend looking it up if you haven't.
When someone buys a property and takes out a mortgage, the first few years of payments will be almost all interest and barely any principle. Most people's eyes will glaze over when they read about an amortisation schedule and the break down of interest to principle in a monthly repayment. Let me illustrate with an example:
Scenario: Jack and Jill takes out a mortgage for $300,000. Principle and interest. 30 year term. Interest rate of 5%.
1.Principal and interest monthly repayments = $1610.46 ; interest=$1250.00, principal=$360.46
2. After 195 months (just over 16 years!) = P+I monthly repayment =$1610.46; interest=$802.88, principal=$807.59. The monthly repayments will now start eroding your loan principal faster and faster from 195 months
3. After 360 months (30 years)= P+I monthly repayment =$1610.46; interest=$6.68, principal=$1603.78. Loan is finally repaid
With a reverse mortgage, you would replay that scenario backwards! Where the 360 month(30th year) redraw from the mortgage of $1610.46 means $1250.00 is the interest charge and you effectively get only $360.46 to spend out of that $1610.46.
But you don't need that much? But you won't be redrawing for that long? It doesn't matter how much or the time frame of the redraw, the amortisation schedule is an eye opener and you are really giving your future, older self a hard time if you take out a reverse mortgage because the interest charge compounded on interest will erode your equity.
You could live to 100 years old and beyond. You could be homeless. I'm not even being dramatic. It's just the way the maths work. So don't take out a reverse mortgage if you have other options or you can avoid it. Just thought I would analyse that for anyone who is trying to do research because it is such a detrimental option but it is being bandied about in the news as an attractive option with no draw backs mentioned or high lighted.
I haven't come across a single article in mainstream news yet that highlights and objectively analyses the pros and cons of reverse mortgages. Only the benefits are discussed.
Showing posts with label All about mortgage loans. Show all posts
Showing posts with label All about mortgage loans. Show all posts
Thursday, September 3, 2015
Wednesday, April 29, 2015
Motto For Wealth: Maximise Income And Minimise Expenses
The story of how to get rich has been trampled over many times by writers, entrepreneurs and dreamers. Even dreamers know the theory but they don't actively apply the theories. For you to grow your wealth and find the holy grail of financial independence, you need to apply all these 'how to get rich theories'.
The very root of how to grow your wealth is really very simple.
Maximise your income by investing in your skills and abilities and therefore you can demand a higher price for your knowledge and skills. On the other hand, you minimise your expenses by actively reducing your spending or reducing your recurring expenses.
I wanted to write about my most recent experiences about reducing recurring expenses. Most of us dislike having to review our insurance bills, our mortgage bills, having to change banks and calling up for quotes.
Having remained with the same bank and same insurance provider for years and years which led to complacency, over the last few months, I thought it was time to take a look at my expenses. A good thing that I did that because my current bank and insurance providers were really having fun at our expense.
1. Cheaper Insurance Policies
Mr SMG and I had seven insurance policies with our current insurer and they gave us a 25% multi-policy discount for having multiple insurances with them covering houses, contents and cars. The 25% 'loyalty' discount is fine and dandy but it really is rubbish when there are more competitive insurers out there that don't even offer the multi-policy discount when they quote but are priced competitively to try and get your business.
A different major insurer offered the same comprehensive insurance at a few hundred dollars cheaper and that was for just one policy. By staying with the previous insurer over the years, they simply kept increasing our premiums every year citing, "there may have been increased theft in your area, there may have been more accidents in your area...blah blah blah."
2. Cheaper Mortgage Interest Rates
Most of us are aware that there are different tiers of mortgage rates out there depending on how much you borrow, the calibre of yourself as a borrower and how much business your provide to your bank (the more fees they earn from you from investment products, the more they love your business). I did some research on the internet and read that some were offered up to 1.3% discount off the standard rate. So I went to ask for interest rate discounts above what we were being offered at 0.91%. It was like hitting a brick wall, "No, no, no, we've given you the best discount that we can offer.".
If at first you don't succeed, you try and try again. So I asked again and then they offered me a 1% discount. A few weeks later, I asked again. I knew there were better rates out there. I was prepared to change my bank but it is rather inconvenient so if they offered me something more competitive, I would remain. I got referred to a personal banker. He obtained a 1.2% discount off our standard variable rates. That 1.2% discount over our current 0.91% discount is going to save us thousands and thousands of dollars across our multiple mortgage loans. Unfortunately I can't quantify it for readers since Mr SMG and I combined our finances. He is a lot more of a private person than I am. It took several visits and phone calls but it was worth it.
3. Question Your Bills and Expenses
This point is mainly for Australians and not for international readers. The NSW Valuer General does the valuation on raw land values every four years. If you own any property, you have to pay council rates. The council uses the Valuer General's figures on your land value to calculate the amount of rates that you have to pay.
Previously, our land was valued at $585k. That's just for the raw land and the dirt underneath our feet. The recent valuation last year came in at $827k. Which is ridiculous having looked at recent sales in our area last year. With a land valuation of $827k and if anything happened to our house and we had to replace our four bedroom house at $500k(for the same house size that we have now), that would value our property at approximately $1.3m plus. Last year, I thought that was out of the question so I wrote to object and they sent a personal valuer out to check out our land. The value was revised downwards to $780k which meant that we saved about $500 in rates payable. That email took 30 minutes to compose and send and it saved us $500.
Having noted recent sales however, the Valuer General's figure was probably spot on for this current market but it wasn't appropriate for the property market last year. We'll just have to take advantage of that for the next four years. Two weeks ago, a house near us sold for a ridiculous $1.7m plus figure and that was just insane but this is the crazy Sydney property market where insanity is the new norm.
The motto for growing your wealth is as applicable as ever. Before we focused on growing our investment income but didn't really focus on minimising expenses that much. It was only when I looked at our bills and realised that all our recurring providers were just increasing our bills beyond inflation and every single year did I realise that it was time to review other providers. It's not fun but it's something that needs to be done.
As the treasurer for one of our strata block properties, I changed the gardeners and cleaners who were charging us $18k for the year to one that charged us only $14k. The previous contractors were simply increasing their fees by almost $1k per annum. With the replacement contractors, the quality and standard of the garden and block is exactly the same. That saved $4k per annum for the past five years which is a $20,000 saving. That was just one aspect.
Don't accept everything that is given to you as fact or as something that you just have to put up with. Question it. Ask around for quotes and be prepared to change providers. Can't emphasise that enough.
The very root of how to grow your wealth is really very simple.
Maximise your income by investing in your skills and abilities and therefore you can demand a higher price for your knowledge and skills. On the other hand, you minimise your expenses by actively reducing your spending or reducing your recurring expenses.
I wanted to write about my most recent experiences about reducing recurring expenses. Most of us dislike having to review our insurance bills, our mortgage bills, having to change banks and calling up for quotes.
Having remained with the same bank and same insurance provider for years and years which led to complacency, over the last few months, I thought it was time to take a look at my expenses. A good thing that I did that because my current bank and insurance providers were really having fun at our expense.
1. Cheaper Insurance Policies
Mr SMG and I had seven insurance policies with our current insurer and they gave us a 25% multi-policy discount for having multiple insurances with them covering houses, contents and cars. The 25% 'loyalty' discount is fine and dandy but it really is rubbish when there are more competitive insurers out there that don't even offer the multi-policy discount when they quote but are priced competitively to try and get your business.
A different major insurer offered the same comprehensive insurance at a few hundred dollars cheaper and that was for just one policy. By staying with the previous insurer over the years, they simply kept increasing our premiums every year citing, "there may have been increased theft in your area, there may have been more accidents in your area...blah blah blah."
2. Cheaper Mortgage Interest Rates
Most of us are aware that there are different tiers of mortgage rates out there depending on how much you borrow, the calibre of yourself as a borrower and how much business your provide to your bank (the more fees they earn from you from investment products, the more they love your business). I did some research on the internet and read that some were offered up to 1.3% discount off the standard rate. So I went to ask for interest rate discounts above what we were being offered at 0.91%. It was like hitting a brick wall, "No, no, no, we've given you the best discount that we can offer.".
If at first you don't succeed, you try and try again. So I asked again and then they offered me a 1% discount. A few weeks later, I asked again. I knew there were better rates out there. I was prepared to change my bank but it is rather inconvenient so if they offered me something more competitive, I would remain. I got referred to a personal banker. He obtained a 1.2% discount off our standard variable rates. That 1.2% discount over our current 0.91% discount is going to save us thousands and thousands of dollars across our multiple mortgage loans. Unfortunately I can't quantify it for readers since Mr SMG and I combined our finances. He is a lot more of a private person than I am. It took several visits and phone calls but it was worth it.
3. Question Your Bills and Expenses
This point is mainly for Australians and not for international readers. The NSW Valuer General does the valuation on raw land values every four years. If you own any property, you have to pay council rates. The council uses the Valuer General's figures on your land value to calculate the amount of rates that you have to pay.
Previously, our land was valued at $585k. That's just for the raw land and the dirt underneath our feet. The recent valuation last year came in at $827k. Which is ridiculous having looked at recent sales in our area last year. With a land valuation of $827k and if anything happened to our house and we had to replace our four bedroom house at $500k(for the same house size that we have now), that would value our property at approximately $1.3m plus. Last year, I thought that was out of the question so I wrote to object and they sent a personal valuer out to check out our land. The value was revised downwards to $780k which meant that we saved about $500 in rates payable. That email took 30 minutes to compose and send and it saved us $500.
Having noted recent sales however, the Valuer General's figure was probably spot on for this current market but it wasn't appropriate for the property market last year. We'll just have to take advantage of that for the next four years. Two weeks ago, a house near us sold for a ridiculous $1.7m plus figure and that was just insane but this is the crazy Sydney property market where insanity is the new norm.
The motto for growing your wealth is as applicable as ever. Before we focused on growing our investment income but didn't really focus on minimising expenses that much. It was only when I looked at our bills and realised that all our recurring providers were just increasing our bills beyond inflation and every single year did I realise that it was time to review other providers. It's not fun but it's something that needs to be done.
As the treasurer for one of our strata block properties, I changed the gardeners and cleaners who were charging us $18k for the year to one that charged us only $14k. The previous contractors were simply increasing their fees by almost $1k per annum. With the replacement contractors, the quality and standard of the garden and block is exactly the same. That saved $4k per annum for the past five years which is a $20,000 saving. That was just one aspect.
Don't accept everything that is given to you as fact or as something that you just have to put up with. Question it. Ask around for quotes and be prepared to change providers. Can't emphasise that enough.
Thursday, July 25, 2013
To Fix The Mortgage Or Not Fix?
Now that we are thoroughly settled into the house and getting used to the new local amenities, travelling arrangements and so forth, it's time to review our finances again.
With a few mortgage payments already made, there's a little bit of routine happening now. Bills are coming fast and furiously with the multiple investments assets but that's fine because the bad stuff(bills and expenses) is exceeded by the greater positive stuff(investment income).
Currently, mortgage interest rates are at historic lows and looks to be staying that way indefinitely until our economy improves. Particularly the mining industry which is in the doldrums and majorly affecting government tax revenue, thus curtailing the government's spending in relation to social welfare and spending on infrastructure.
To Fix Or Not Fix The Mortgage Rates?
Hamlet(or rather Shakespeare) posed the question, "to be or not to be?" ... although he faced an existential crisis, our crisis is not as dramatic but rather a financial issue.
While interest rates are at record lows, they can be lowered even further. However on the other hand, if the economy improved then the rates would head upwards again to curtail inflation. 50/50 really.
The house mortgage is currently a 100% variable mortgage loan attached with features such as unlimited repayments, ability to redraw, 100% offset facility and the interest is at 5.25%.
If we were to fix, the interest rate would be 4.99% with the option to fix for two or three years. By fixing a portion of the mortgage, that fixed portion would then be stymied by the ability to only make a maximum of $10k in extra repayments per annum and there's probably a limit applicable for redraws(will have to check the terms and conditions), penalties and limits to loan portability, penalties on breaking fixed loans and the offset account will no longer be 100% offset against the fixed loan component.
I've been contemplating on fixing 50% of the loan because I prefer certainty to uncertainty and if interest rates were to drop further, that's okay. BUT if interest rates were to rise then that could possibly hamper our lifestyle somewhat and pose new financial challenges.
Property Planning Australia wrote a short little article which illustrates reasons that are to be considered prior to fixing which I thought was rather useful and may be of help to you if you're facing a similar scenario:
"• Would you like more certainty in knowing what your loan repayments will be?• Do you feel like you are stretched with your cash flow?• Do you have little equity or cash buffer to draw upon if things got tougher?• Are you risk averse?• If rates kept going lower after you fix, would you be comfortable knowing that you cannot access the lower variable rate without a hefty penalty that would almost certainly make it non-beneficial to get out of your higher fixed rate?• Are you confident that you will not sell your house or want to refinance during the fixed rate period?• Do you have non-deductible and deductible debt, and would you feel more comfortable knowing that you had a set repayment for part or all of one or the other?Did You Know That You Can Fix Your Mortgage Loan In Multiple Structures?
If you answer yes to many of these questions, then you are starting to build a case for fixing your debt."
I was thinking about fixing and how it would throw a spanner in the works against making unlimited extra repayments due to the $10k limit on extra repayments...then the question arose, what if we could have multiple fixed portions? That would mean the extra repayments would only be capped by the structure that we've set up. Thought that was too good to be true, however a trip to the bank confirmed that YES it was possible to have several concurrent fixed loan components and each fixed loan component has the facility to accept $10k in extra repayments per annum!
That means that instead of the original structure that I was considering, I could have a better structure that was more flexible. We could even have 5 fixed loan components which would allow $50k in extra repayments per annum in addition to the unlimited extra repayment on the variable portion if we were really that flush with spare funds.
Structure 1:
50% variable at 5.25%, 50% fixed at 4.99% for two years
Thus extra repayments on fixed portion capped at $10k per annum while extra repayments on variable portion is unlimited
Structure 2:
50% variable at 5.25%, 25% fixed at 4.99% for two years and 25% fixed at 4.99% for three years
Thus extra repayments on fixed portions capped at total of $20k per annum while extra repayments on variable portion is unlimited
When I queried the branch manager on why people didn't structure their loan with the greatest flexibility, she replied that not many people knew about structuring and even if you tried explaining or suggesting the structure to them they would get confused, so her work was to help people arrange what they wanted.
As mentioned before in previous posts, I haven't got a crystal ball for the future, however with our current loan, I would like some certainty regarding mortgage repayments. On the other hand, I don't want to limit our ability to make extra repayments so the best option for our scenario is to go ahead with Structure 2 and restructure the mortgage into three parts.
Monday, May 23, 2011
Borrowing $400,000 from the bank
My bank ran some preliminary numbers and said that they can probably arrange a pre-approval for me to borrow $400,000. And that's on top of my current loan commitment. The average Australian loan is about $360,000. If I were to fully leverage myself, then my aggregate investment loan balance would vastly exceed the average loan.
Would you borrow that much?
If your bank offered you an additional loan of $400,000, would you accept their offer?
I'd be crazy to borrow the maximum amount and gear myself to that extent. It's a bad move to over-leverage and also a bad move to under-leverage.
Why is it bad to be under-leveraged? Currently, I'm under-leveraged which means that I have the potential to buy more investment assets and service a greater loan. This can potentially translate to greater passive income and capital gains but I'm not taking advantage of that because I'm under-leveraged. Next year I plan to buy another investment so that should sort out the under-leveraging situation. Although I wouldn't borrow the maximum because that could topple like a house of cards.
Why is over-leveraging risky? No-one should be borrowing up to their maximum servicing capacity(your ability to repay loans) because it doesn't leave any rooms for errors, disruption to the income stream (job loss or fluctuations in business revenue) and it'll probably be rather stressful when you're walking on a financial tight rope. If you subject yourself to high risks, then you're subjecting yourself to the risk of having to liquidate your investments (shares or property) at an inopportune time, therefore, realising your losses and not having the ability to ride out asset price fluctuations.
How do you work out repayments?
I use my favourite site yourmortgage.com.au for their advanced repayment calculator. Although I've compiled my own spreadsheet with inbuilt formulas so no longer use this site but I recommend this one. Why? They have a fantastic loan repayment calculator. It's accurate and doesn't do shabby rounding ups and downs that ultimately give users inaccurate numbers like some of the other online calculators that I've checked out.
A loan of $400,000 at 8% for a loan term of 30 years means repayments of:
$2935.06/month OR
$1354.06/fortnight OR
$676.91/week
Of course, if you are buying an investment then you'll be earning investment income so that could contribute towards the repayment. If you're in Australia, then you also get a tax deduction for interest paid and a raft of other tax deductions associated with the maintenance of your investment. After all these deductions, the cost that's coming out of your own pocket is significantly less.
What if I want to instead, maximise my borrowings?
If I really wanted to borrow the maximum, then I would be refinancing my current investments down to a loan valuation ratio(LVR) of 20% so that I could borrow up to 80%.
By doing this, then for every $1 that I have, I can borrow $4. This is how I can fully gear myself and risk over-leveraging:
- If I have $100k then I can borrow $400k for a $500k investment.
- If I have $200k then I can borrow $800k for a $1 million investment.
- If I have $300k then I can borrow $1.2 million for a $1.5 million investment
Further reading:
1. 15 Tips On Paying Off Your Mortgage Faster
2. Understanding Loans and Their Features
3. Paying off your mortgage faster - The scenarios
Thursday, November 4, 2010
Mortgage rate rises causing mortgage arrears
Loan defaults have been increasing
The last six rate rate rises in Australia has resulted in increasing loan defaults. Unlike our overseas counterparts, our average home loans are around the $300,000 amount. Here's an extract from the news.com.au:
A multitude of circumstances and unfortunate events may have resulted in people's inability to meet their mortgage payments: poor health, injury, sickness, loss of job/jobs, cut in hours, unexpected bills and expenses and a gazillion other reasons that I have not listed.
There are a few steps that you could take to ensure that you minimise the risk of mortgage defaults and being in arrear on your mortgage.
If you have a mortgage already:
* Ensure you build up an emergency fund(EF) to cover mortgages, bills and expenses (with extra to cover for unexpected expenses like your car breaking down suddenly) for the duration that it may take you to find a new job if you are unexpectedly unemployed. If you're in a tough industry and it may take 1 year to find work, then your EF should cover 1 years worth of expenses
* Have funds in a separate saving account or in liquid (easy to convert to cash) investments that can meet your mortgage payments for the duration that you are job hunting and not earning an income. This ensures that you will not fall into arrear and will not be paying extra costs for defaults and cheques bouncing and incurring overdrafts.
* If your account doesn't allow you to withdraw your extra repayments, it is really important to ensure that you have separate savings instead of ploughing extra money directly into paying off your mortgage. If you're in Australia, it's preferable to setup a separate offset account so that you can deposit any extra funds you've got into it rather than directly into your mortgage. With an offset account, it doesn't matter whether you're employed or unemployed, you can always make withdrawals. The terms of some mortgages specify that if someone is unemployed, they cannot withdraw their extra repayments. This is an important restrictive condition to watch out for.
* Make sure you have backup plans in the event that you lose your income
* If you're serious about building your wealth and obtaining financial freedom, you should avoid refinancing your mortgage to buy trivial depreciating goods such as boats, cars and holidays.
If you haven't got a mortgage but are planning to buy:
* Form a budget so you know what all your expense are and how much you can afford each month. If after you know what your income and expenses are and you can allocate $1500/month towards a mortgage for example, then pretend you have a mortgage to pay and ensure that you can easily save that $1500/month. Maintain this for a few months to see whether you can cope with that level of repayment.
* Don't borrow the maximum the bank approves you to borrow. I can't stress that point enough. The bank will always be keen to loan you more than you're comfortable with repaying and in many recent mortgage defaults, more than they can afford to repay after a few interest rate rises. Just because the bank approves a $500,000 loan, doesn't mean you should go out and buy a $500,000 house if all you need for you (and your family) is a $350,000 house for example.
* Always buy your first house with a 20% deposit at least. That way you don't have to pay LMI (Lender Mortgage Insurance) and it demonstrates to yourself (and the bank of course) that you can save something. If you're a risk taker, you can always buy with no deposit but if you can't even save some amount for a deposit, what makes you think that you can pay your mortgage regularly without falling into arrears?
* The exception to the rule: If you pay rent without any problems every week or month, as long as your mortgage payments are roughly equivalent to your rental payments, then you're more likely to beable to buy even without a deposit. Although, being a home owner does come with additional expenses such as repairs and maintenance - expenses which you previously didn't have to pay for, when you were renting.
Buying a property means having to do some serious number crunching and risk analysis. Always factor in the risk that interest rates will increase. The risk that you will have to do repairs and maintenance on your place. The risk that something will break down or leak. The risk that if you are buying an investment property, you may have difficulty finding renters and tenants. The risk that your expected cash flows may not materialise. The risk that you may become unemployed or experience a drop in income.
As they say, the plans could go awry, but having a plan is always better than no plan.
The last six rate rate rises in Australia has resulted in increasing loan defaults. Unlike our overseas counterparts, our average home loans are around the $300,000 amount. Here's an extract from the news.com.au:
Real Estate Institute of Queensland managing director Dan Molloy said the August spike showed the typical lag between rate rises and the impact on homeowners.Imagine trying to find an extra $300 each month when you've been living a pretty bare existence already. When you've been living paycheck to paycheck just barely meeting mortgage payments.
A multitude of circumstances and unfortunate events may have resulted in people's inability to meet their mortgage payments: poor health, injury, sickness, loss of job/jobs, cut in hours, unexpected bills and expenses and a gazillion other reasons that I have not listed.
There are a few steps that you could take to ensure that you minimise the risk of mortgage defaults and being in arrear on your mortgage.
If you have a mortgage already:
* Ensure you build up an emergency fund(EF) to cover mortgages, bills and expenses (with extra to cover for unexpected expenses like your car breaking down suddenly) for the duration that it may take you to find a new job if you are unexpectedly unemployed. If you're in a tough industry and it may take 1 year to find work, then your EF should cover 1 years worth of expenses
* Have funds in a separate saving account or in liquid (easy to convert to cash) investments that can meet your mortgage payments for the duration that you are job hunting and not earning an income. This ensures that you will not fall into arrear and will not be paying extra costs for defaults and cheques bouncing and incurring overdrafts.
* If your account doesn't allow you to withdraw your extra repayments, it is really important to ensure that you have separate savings instead of ploughing extra money directly into paying off your mortgage. If you're in Australia, it's preferable to setup a separate offset account so that you can deposit any extra funds you've got into it rather than directly into your mortgage. With an offset account, it doesn't matter whether you're employed or unemployed, you can always make withdrawals. The terms of some mortgages specify that if someone is unemployed, they cannot withdraw their extra repayments. This is an important restrictive condition to watch out for.
* Make sure you have backup plans in the event that you lose your income
* If you're serious about building your wealth and obtaining financial freedom, you should avoid refinancing your mortgage to buy trivial depreciating goods such as boats, cars and holidays.
If you haven't got a mortgage but are planning to buy:
* Form a budget so you know what all your expense are and how much you can afford each month. If after you know what your income and expenses are and you can allocate $1500/month towards a mortgage for example, then pretend you have a mortgage to pay and ensure that you can easily save that $1500/month. Maintain this for a few months to see whether you can cope with that level of repayment.
* Don't borrow the maximum the bank approves you to borrow. I can't stress that point enough. The bank will always be keen to loan you more than you're comfortable with repaying and in many recent mortgage defaults, more than they can afford to repay after a few interest rate rises. Just because the bank approves a $500,000 loan, doesn't mean you should go out and buy a $500,000 house if all you need for you (and your family) is a $350,000 house for example.
* Always buy your first house with a 20% deposit at least. That way you don't have to pay LMI (Lender Mortgage Insurance) and it demonstrates to yourself (and the bank of course) that you can save something. If you're a risk taker, you can always buy with no deposit but if you can't even save some amount for a deposit, what makes you think that you can pay your mortgage regularly without falling into arrears?
* The exception to the rule: If you pay rent without any problems every week or month, as long as your mortgage payments are roughly equivalent to your rental payments, then you're more likely to beable to buy even without a deposit. Although, being a home owner does come with additional expenses such as repairs and maintenance - expenses which you previously didn't have to pay for, when you were renting.
Buying a property means having to do some serious number crunching and risk analysis. Always factor in the risk that interest rates will increase. The risk that you will have to do repairs and maintenance on your place. The risk that something will break down or leak. The risk that if you are buying an investment property, you may have difficulty finding renters and tenants. The risk that your expected cash flows may not materialise. The risk that you may become unemployed or experience a drop in income.
As they say, the plans could go awry, but having a plan is always better than no plan.
Wednesday, October 7, 2009
Paying off your mortgage faster- the scenarios
This particular article of mine is very long and I hope, valuable to you as a reader. It will go into depths with the numbers, figures and examples. If you need to take a break in between, I suggest you do that. I would value a comment feedback if you found this helpful, and if you comment with an outline of your own mortgage structure, that would be interesting.
There are pros and cons of paying off the mortgage faster, however this particular article of mine is only concerned with how to pay off your mortgage faster and what the financial effects are if you pursue various repayment options.
Decades ago, housing was 2-3 times the average annual wage, in modern days, housing is now 5-6 times and more the average annual wage.
Because of this, it’s more important than ever to know how to organize your payments so that you can pay your mortgage off faster, rather than letting the repayments consume the next 25-30 years of your life. Why would the banks advise you how to pay off your mortgage faster? There would be less profit for them if they did that.
If you are using property as a wealth creation vehicle, then this article isn’t strictly appropriate for you. Using property as a vehicle to build wealth, would involve maximizing your investment loans (tax deductible), leverage (LVR) and the amount of properties under your control and it does not necessarily include the goal of paying off your mortgage loans faster.
Paying off any non-deductible debt such as the mortgage on your principal place of residence (PPOR), that is, the home that you live in right now, can be easy by understanding how a mortgage works. You can knock anything from 5-25 years off your mortgage. There are books out there that boast that they paid their mortgage off in 3years. This is possible and achievable if your mortgage isn’t more than 3 times your annual income! Most mortgages though, with the right payment structure setup, can be paid off within 3-10 years.
If you earn $60,000 per annum, and your mortgage is $300,000 then it will take more than 5 years to pay off. Why? $60,000 income, deduct taxes, living expenses, mortgage interest and you can already see that you can’t pay it off in 5 years unless something changes – either you earn more or you spend less. Your target could be to pay it off in 5-10 years. Set reasonable goals and targets.
The ability to pay off your mortgage quickly depends largely on your income but you can learn a few repayment techniques which can help you pay off your mortgage faster, regardless of your income. See my article about “15 Tips on paying off your mortgage faster” filed under the label “All about mortgage loans.”
Once you understand how the loan amortization schedule works, you will be in control of paying your mortgage off faster. I will illustrate a few scenarios and change a few criterias so that you can see the flow on effect of how altering your payments can save you from higher interest charges.
Example:
A few assumptions: Interest rate is variable but will remain unchanged for 30 years for simplicity. I’ve rounded up or down to the nearest dollar. The average loan amount is $300k so I’ll use that for my calculations
Purchase price of house: $375k ($375,000)
20% deposit: $75k
80% mortgage loan amount also known as the principle: $300k
Variable interest rate: 8%
Loan period: 30 years = 360 months
Repayment: Principle + Interest loan
LVR: $300k/375k thus LVR is 80%
Monthly repayment is $2,201 composed of:
Principal: $201
Interest: $2,000
***************
Scenario 1)
You make the same $2,201 payment each month for the next 30 years. No extra repayments. As you can see, your very first mortgage payment, $2,000 goes into the bank’s pocket, and only a measly $201 is applied to reduce your principal loan (the $300,000), leaving you with a loan balance of $299,799
After each month’s payment, you are knocking a further pitiful $1 to $2 or so amount off the principal amount. After one year of paying your mortgage, you feel like you’ve gotten no-where.
You’re absolutely right, you’ve gotten no-where because across that first year, you’ve diligently paid $2,201 each month but out of that - you have paid the bank a whopping $23,909 interest and you’ve knocked only $2,506 off your principle. Leaving your loan balance at $297,494
This is the amortization chart for the first year of your mortgage with this scenario:
Year Month Repayment Interest PrincipalBalance
1 1 2,201.29 2,000.00 201.29 299,798.71
1 2 2,201.29 1,998.66 202.63 299,596.08
1 3 2,201.29 1,997.31 203.98 299,392.10
1 4 2,201.29 1,995.95 205.34 299,186.76
1 5 2,201.29 1,994.58 206.71 298,980.05
1 6 2,201.29 1,993.20 208.09 298,771.96
1 7 2,201.29 1,991.81 209.48 298,562.48
1 8 2,201.29 1,990.42 210.87 298,351.61
1 9 2,201.29 1,989.01 212.28 298,139.33
1 10 2,201.29 1,987.60 213.69 297,925.64
1 11 2,201.29 1,986.17 215.12 297,710.52
1 12 2,201.29 1,984.74 216.55 297,493.97
23,909.45 2506.03
Holy cr@p, you didn’t know you paid that much interest right? You may be one of the few that do know, but there are many people out there, clueless about this breakdown, paying their mortgage, month after month, year after year, and getting frustrated about why they haven’t managed to pay off anything.
Ten years later, you’re still doing the same old monthly payment, month in, month out, blissfully unaware that by the end of the tenth year, you have paid the bank, interest totaling $227,330! And how much principal have you knocked off the loan? Only $36,825! And what’s the balance of your loan to pay? $263,175
The ball is in your court when you reach the 22nd year of your mortgage, after 257 months worth of $2,201/month payments, your interest component is $1,098 and principal component $1,103, leaving your mortgage loan balance at $163,647
Now after 22 years it’s in your favour. It had taken you 22 years to pay off $136,353and the next 8 years to pay off $163,647 in principal.
Why did you suddenly pay off 55% of the loan in the last 8 years and it took you 22 years to pay off 45%?
It’s because the principal component finally exceeded the interest component of your monthly repayments. Finally after 30 years of $2201/month repayments later, you finally paid off your mortgage and you’ve also paid the bank $492,471 in total interest. A total balance of $792,471!
***************
Scenario 2)
Same amount borrowed (300k), same interest rate (8%) for the same period (30years)
Same repayment amount at $2,201/month
Except in this example, you earned a $2,000 bonus at work the second month into your mortgage and you decide to pay this lump sum into your mortgage to reduce the principal loan by $2000. I will now show you how much that $2000 saved you across the life of the loan.
•You will be mortgage free 9 months earlier
•You will end up paying a total interest of $473,360
•This saves you paying interest of $19,111 across the life of the loan…all this interest saved for just making a lump sum repayment into your mortgage at the beginning of the loan
***************
Scenario 3)
Same amount borrowed (300k), same interest rate (8%) for the same period (30years)
Same repayment amount at $2,201/month
Except in this example, you earned a $2,000 bonus at work at the end of the third year (36 months) into your mortgage and you decide to pay this lump sum into your mortgage to reduce the principal loan by $2000. I will now show you how much that $2000 saved you across the life of the loan. It will be less of a saving than scenario 2 because the earlier you make the extra repayments, the more interest you save:
•You will be mortgage free 7 months earlier
•You will end up paying a total interest of $477,522
•This saves you paying interest of $14,949 across the life of the loan…all this interest saved for just making a lump sum repayment into your mortgage at the end of the third year of your loan
***************
Scenario 4)
Same amount borrowed (300k), same interest rate (8%) for the same period (30years)
Same repayment amount at $2,201/month
Except in this example, you earned a $2,000 bonus at work the second month into your mortgage and you decide to pay this lump sum into your mortgage to reduce the principal loan by $2000. Not only that, you decide to give up buying coffee for three days of the week (latte effect) saving you $3 x 3 days x 4 weeks equals $36/month in savings. You can really sacrifice anything you like to come up with the savings. I’m just using a very simple, easy to achieve sacrifice as an example.
Your extra repayments are now $2000 in month two and $36/month until you pay the mortgage off:
•You will be mortgage free 2 years and 6 months earlier!!
•You will end up paying a total interest of $439,204
•This saves you paying interest of $53,267 across the life of the loan
All this interest saved for just making a lump sum repayment early on in our mortgage and the extra small amount of $36 that you were paying every month on top of your regular $2201/month payment.
It’s simple little things like what I’ve hypothesized for you above that makes a huge difference in how you can pay your mortgage off faster and how you can save thousands of dollars in interest. Making extra repayments means that you’ve utilized the power of compounding in your favour rather than letting the bank use compounding in their favour to charge you interest.
You can use mortgage calculators and amortization schedules to do your own scenarios. My intentions are just to demonstrate how a few simple extra payments and how you pay those payments against your home loan, can shorten your loan and also save you thousands of dollars in interest.
There are pros and cons of paying off the mortgage faster, however this particular article of mine is only concerned with how to pay off your mortgage faster and what the financial effects are if you pursue various repayment options.
Decades ago, housing was 2-3 times the average annual wage, in modern days, housing is now 5-6 times and more the average annual wage.
Because of this, it’s more important than ever to know how to organize your payments so that you can pay your mortgage off faster, rather than letting the repayments consume the next 25-30 years of your life. Why would the banks advise you how to pay off your mortgage faster? There would be less profit for them if they did that.
If you are using property as a wealth creation vehicle, then this article isn’t strictly appropriate for you. Using property as a vehicle to build wealth, would involve maximizing your investment loans (tax deductible), leverage (LVR) and the amount of properties under your control and it does not necessarily include the goal of paying off your mortgage loans faster.
Paying off any non-deductible debt such as the mortgage on your principal place of residence (PPOR), that is, the home that you live in right now, can be easy by understanding how a mortgage works. You can knock anything from 5-25 years off your mortgage. There are books out there that boast that they paid their mortgage off in 3years. This is possible and achievable if your mortgage isn’t more than 3 times your annual income! Most mortgages though, with the right payment structure setup, can be paid off within 3-10 years.
If you earn $60,000 per annum, and your mortgage is $300,000 then it will take more than 5 years to pay off. Why? $60,000 income, deduct taxes, living expenses, mortgage interest and you can already see that you can’t pay it off in 5 years unless something changes – either you earn more or you spend less. Your target could be to pay it off in 5-10 years. Set reasonable goals and targets.
The ability to pay off your mortgage quickly depends largely on your income but you can learn a few repayment techniques which can help you pay off your mortgage faster, regardless of your income. See my article about “15 Tips on paying off your mortgage faster” filed under the label “All about mortgage loans.”
Once you understand how the loan amortization schedule works, you will be in control of paying your mortgage off faster. I will illustrate a few scenarios and change a few criterias so that you can see the flow on effect of how altering your payments can save you from higher interest charges.
Example:
A few assumptions: Interest rate is variable but will remain unchanged for 30 years for simplicity. I’ve rounded up or down to the nearest dollar. The average loan amount is $300k so I’ll use that for my calculations
Purchase price of house: $375k ($375,000)
20% deposit: $75k
80% mortgage loan amount also known as the principle: $300k
Variable interest rate: 8%
Loan period: 30 years = 360 months
Repayment: Principle + Interest loan
LVR: $300k/375k thus LVR is 80%
Monthly repayment is $2,201 composed of:
Principal: $201
Interest: $2,000
***************
Scenario 1)
You make the same $2,201 payment each month for the next 30 years. No extra repayments. As you can see, your very first mortgage payment, $2,000 goes into the bank’s pocket, and only a measly $201 is applied to reduce your principal loan (the $300,000), leaving you with a loan balance of $299,799
After each month’s payment, you are knocking a further pitiful $1 to $2 or so amount off the principal amount. After one year of paying your mortgage, you feel like you’ve gotten no-where.
You’re absolutely right, you’ve gotten no-where because across that first year, you’ve diligently paid $2,201 each month but out of that - you have paid the bank a whopping $23,909 interest and you’ve knocked only $2,506 off your principle. Leaving your loan balance at $297,494
This is the amortization chart for the first year of your mortgage with this scenario:
Year Month Repayment Interest PrincipalBalance
1 1 2,201.29 2,000.00 201.29 299,798.71
1 2 2,201.29 1,998.66 202.63 299,596.08
1 3 2,201.29 1,997.31 203.98 299,392.10
1 4 2,201.29 1,995.95 205.34 299,186.76
1 5 2,201.29 1,994.58 206.71 298,980.05
1 6 2,201.29 1,993.20 208.09 298,771.96
1 7 2,201.29 1,991.81 209.48 298,562.48
1 8 2,201.29 1,990.42 210.87 298,351.61
1 9 2,201.29 1,989.01 212.28 298,139.33
1 10 2,201.29 1,987.60 213.69 297,925.64
1 11 2,201.29 1,986.17 215.12 297,710.52
1 12 2,201.29 1,984.74 216.55 297,493.97
23,909.45 2506.03
Holy cr@p, you didn’t know you paid that much interest right? You may be one of the few that do know, but there are many people out there, clueless about this breakdown, paying their mortgage, month after month, year after year, and getting frustrated about why they haven’t managed to pay off anything.
Ten years later, you’re still doing the same old monthly payment, month in, month out, blissfully unaware that by the end of the tenth year, you have paid the bank, interest totaling $227,330! And how much principal have you knocked off the loan? Only $36,825! And what’s the balance of your loan to pay? $263,175
The ball is in your court when you reach the 22nd year of your mortgage, after 257 months worth of $2,201/month payments, your interest component is $1,098 and principal component $1,103, leaving your mortgage loan balance at $163,647
Now after 22 years it’s in your favour. It had taken you 22 years to pay off $136,353and the next 8 years to pay off $163,647 in principal.
Why did you suddenly pay off 55% of the loan in the last 8 years and it took you 22 years to pay off 45%?
It’s because the principal component finally exceeded the interest component of your monthly repayments. Finally after 30 years of $2201/month repayments later, you finally paid off your mortgage and you’ve also paid the bank $492,471 in total interest. A total balance of $792,471!
***************
Scenario 2)
Same amount borrowed (300k), same interest rate (8%) for the same period (30years)
Same repayment amount at $2,201/month
Except in this example, you earned a $2,000 bonus at work the second month into your mortgage and you decide to pay this lump sum into your mortgage to reduce the principal loan by $2000. I will now show you how much that $2000 saved you across the life of the loan.
•You will be mortgage free 9 months earlier
•You will end up paying a total interest of $473,360
•This saves you paying interest of $19,111 across the life of the loan…all this interest saved for just making a lump sum repayment into your mortgage at the beginning of the loan
***************
Scenario 3)
Same amount borrowed (300k), same interest rate (8%) for the same period (30years)
Same repayment amount at $2,201/month
Except in this example, you earned a $2,000 bonus at work at the end of the third year (36 months) into your mortgage and you decide to pay this lump sum into your mortgage to reduce the principal loan by $2000. I will now show you how much that $2000 saved you across the life of the loan. It will be less of a saving than scenario 2 because the earlier you make the extra repayments, the more interest you save:
•You will be mortgage free 7 months earlier
•You will end up paying a total interest of $477,522
•This saves you paying interest of $14,949 across the life of the loan…all this interest saved for just making a lump sum repayment into your mortgage at the end of the third year of your loan
***************
Scenario 4)
Same amount borrowed (300k), same interest rate (8%) for the same period (30years)
Same repayment amount at $2,201/month
Except in this example, you earned a $2,000 bonus at work the second month into your mortgage and you decide to pay this lump sum into your mortgage to reduce the principal loan by $2000. Not only that, you decide to give up buying coffee for three days of the week (latte effect) saving you $3 x 3 days x 4 weeks equals $36/month in savings. You can really sacrifice anything you like to come up with the savings. I’m just using a very simple, easy to achieve sacrifice as an example.
Your extra repayments are now $2000 in month two and $36/month until you pay the mortgage off:
•You will be mortgage free 2 years and 6 months earlier!!
•You will end up paying a total interest of $439,204
•This saves you paying interest of $53,267 across the life of the loan
All this interest saved for just making a lump sum repayment early on in our mortgage and the extra small amount of $36 that you were paying every month on top of your regular $2201/month payment.
It’s simple little things like what I’ve hypothesized for you above that makes a huge difference in how you can pay your mortgage off faster and how you can save thousands of dollars in interest. Making extra repayments means that you’ve utilized the power of compounding in your favour rather than letting the bank use compounding in their favour to charge you interest.
You can use mortgage calculators and amortization schedules to do your own scenarios. My intentions are just to demonstrate how a few simple extra payments and how you pay those payments against your home loan, can shorten your loan and also save you thousands of dollars in interest.
15 Tips on paying off your mortgage faster
1)Firstly, have a decent deposit.
20% deposit minimum will save you having to pay lender’s mortgage insurance which is also known as LMI. LMI protects the bank, and not you, if you default on your loan
2)Get a loan with only the features you need at the lowest rate.
It MUST be flexible enough to allow you to make extra repayments, allow redraw and 100% offsets without penalising you
Getting the right loan with the appropriate features in the first place may save you from having to refinance and pay penalties later on. Some loan features to consider are: ability to redraw, make extra repayments, switch between fixed or variable rates, take repayment holidays, offset accounts, line of credit accounts and your loan portability are just a few features.
3)Be wary of “introductory rates”, “honeymoon rates” and “low start” rates.
They typically have lower interest rate for 6-12 months but may not allow additional repayments, thus costing you more in the end.
4)Make your first repayment on settlement date.
Don’t wait for the first payment at the end of the month and this will save you thousands of dollars
5)Pay your purchasing fees upfront and do not capitalize them into your loan.
Fees such as establishment fees, stamp duty fees, legal fees and Lenders Mortgage Insurance fees (LMI). This will save thousands of dollars.
6) Don’t pay your mortgage monthly, but pay it fortnightly.
This ensures you make one extra payment per year which cuts 7 to 8 years off a 30 year mortgage term.
7)Have your salary deposited directly into your mortgage offset account.
That way, the salary is reducing the interest payable from day one.
8)Make extra repayments(consistent or ad-hoc) as often as you can, or make payments that are bigger than the amount required.
EG: if your fortnightly repayment amount is $500, try and pay $600 per fortnight or more if you can afford it.
9)Make sure your extra repayments are deducted from the principle owing, and not recorded as a prepayment of interest.
Check your statements! Contact the bank if this isn’t happening.
10)Interest is calculated daily
So extra repayments made in the early days will reduce your loan principal immediately, reaping a far greater benefit on saving you interest than extra repayments made in the later years
11)Sign up for the professional package.
See your bank to see what they have available. Professional packages can be free or cost up to $400-500 in fees per annum but save you thousands of dollars of interest per annum. It may have features such as a discount on your loan rate, no annual fee credit card, no account or transaction management fees on your account(Eg: CBA Wealth Package)
12)Be careful with the loan amount that you fix the rate on and the fixed term period.
If you’ve fixed too much for too long, this restricts your ability to make extra repayments (usually limited at $10k pa). Or you can be penalized for breaking the loan if you wish to relocate to a new property (portability) and close the loan off. Penalty fees for breaking fixed loans are very exorbitant and can be up to even $40,000 to break.
13)If your bank reduced the loan interest rate, maintain your monthly repayment amount instead of reducing it.
This will ensure you pay off more loan principal because the ratio of interest to principal has changed due to the interest component decreasing. In Australia, banks ordinarily maintain your monthly payments when rates go down (which is a good thing for you!), unless you contact them to change the monthly repayment amounts.
14)Rent out your spare rooms.
Take on some renters and rent those spare rooms out. This could provide you with 300- 1000 per month (for each room) in extra income to pay off your mortgage faster. This can save you thousands, the earlier you do it, the better the results. The bonus is that you don’t even have to work hard for the income. Let your property pay for itself!
15)Check your mortgage contract for any early prepayment penalties and/or deferred establishment fees that may be applicable.
These could cost you up to $700 and more depending on the penalty stipulated on your loan contract. Deferred establishment fees are usually charged when you pay off your loan within 3 or 4 years of the loan start date. This differs between lenders and is usually stated on your loan contract.
Why would anyone pay their mortgage off early when they can invest that extra amount instead?
Roughly, each $1000 you owe on the mortgage, you will end up paying $2,500 to $3000 to the lender in return if you pay according to their required monthly payment amount and do not make any extra repayments.
The earlier you make those extra payments above the required mortgage amount the bank has stipulated for you, the quicker you will pay off your loan and end up saving yourself thousands of dollars, not to mention, you may also be among the rare few to pay off your mortgage loan in less than three years.
Paying off your mortgage quickly may not always be an ideal (or the best) financial goal, but for most people, it’s better to have this as a goal to aim towards than to have no goals at all. Without any financial goals, we trend towards excessive consumption(of crap) and buying too much useless consumer goods. If you can earn more from investing, then it’s always better to invest than to pay off your mortgage early. The challenging part is finding an investment that yields something worthy of your attention.
But I can earn more if I invested the extra amount saved instead of dumping it into my mortgage?
If your mortgage loan rate is 6% pa, each dollar that you pay off your loan principle is in essence, earning 6% pa tax free for you for the life of your mortgage loan, whether that be 1 year or 30 years. That’s equivalent to 6% after tax. If your tax rate was 40%, your investment returns will need to yield at least 10%pa to even justify you not paying off the mortgage with that extra dollar.
Many people are now fearful of the share market and investing in stocks, properties, mutual/managed funds, superannuation and retirement accounts. How could you not feel wary when the market has been as volatile as it has been in 2007, 2008 and 2009? Portfolios and asset values plunged by up to 60% and more. Property values careening below the value of the mortgage loan (particularly in the US) and retirement savings annihilated worldwide.
For these reasons, paying off your mortgage faster is a sure fire way to build equity in your property without as much volatility as investing…not to mention the huge peace of mind that you get, especially if you’re at the retirement(older) end of the spectrum.
I’ve read somewhere that in the US, mortgages are supposedly tax deductible. The problem with tax deductions is that people are so misguided with this feature that they do not try to pay off their mortgages early (so that they can maximize their tax deductions). Instead, the unwise ones will pay only the minimum mortgage amount required and with the funds left over…it’s spent on consumption, keeping up with the joneses and buying flashy cars.
If you can find investments that yield more than the interest charge you pay on your mortgage, go ahead and invest those extra funds. Although, just be sure to adjust the yield rate for taxes before you compare it to your mortgage interest rate.
On that note, I have to say, choose your path and walk your own road.
Subscribe to:
Comments (Atom)