Split loans can aid payment goals
Glen McLeod lists the pros and cons of splitting your home loan.
QWe have some acquaintances who have been following an aggressive policy to pay off their home loan. We don’t know them well enough to ask for how to do it exactly but it generally goes something like this: An amount fixed long term, an amount fixed medium term and an amount fixed for a year. The long-term fixed amounts are paid at the minimum repayment whereas the year fixed term is set and repaid at a rate that the whole amount will be paid off within the year. Does this kind of strategy actually pay it off faster? I can’t make the maths work.
ABroadly, anything that increases your efforts to pay down some of your loan more quickly should save you money in the long run. People sometimes separate out an amount like this to focus on and get rid of because it helps them to target their repayments and gives the extra sense of satisfaction when a small loan is paid off.
Loans are sometimes split as you describe to avoid the whole amount rolling off just as interest rates are hitting a peak.
McLeod says when it comes to saving interest on your mortgage, there is no secret formula. ‘‘The reality is that the way to save yourself interest is to make extra payments whenever possible.’’
He says how your loan is set up will depend on a number of factors, including what is happening with interest rates, your income, how much you can afford to repay and the products your lender offers.
‘‘Let’s start with interest rates. If the interest rate market is rising, then it is highly likely that when you are fixing your loan you will get a recommendation for a longerterm interest rate,’’ he said.
‘‘This is due to not wanting to complete a number of different loan splits where one might be coming off at one year, two years and then three years. The reason for this is that each year is an opportunity for interest rates to increase, therefore increasing your payments.’’
But, he says, if interest rates are falling, then a one-year rate could be better. ‘‘That being said it is important to actually discuss this with your adviser to ensure that you don’t get yourself into a situation where you experience rate shock because the loan that you have is so large any increase would be detrimental to your serviceability. And in that case it might be best to split the loan into two.’’ He says someone with a $500,000 home loan and a threeyear rate of 5.39% over a 30-year term will have a monthly payment of $2804.
‘‘Let’s also say your budget enables you to make payments of $3000 a month towards your mortgage. In this particular case I would be suggesting that you do put the full $3000 towards your payment each month. The extra $195 a month would mean that your loan term would decrease by four years and you would save $85,353.31 in interest if this was continued for the full term of your loan.’’
He says some people will also pay off their loan faster by making lump sum payments on to their loans. When interest rates are rising, it is easier to do this without a penalty.
‘‘Effectively if your interest rate was 5.39% for three years fixed and six months down the track the interest rate for your remaining time was sitting around 6.5%, you may have no break costs at all. [That would] enable you to make a lump sum reduction which saves you interest and reduces the term of your loan. My suggestion would be to continue with your higher mortgage repayments even though you have reduced your loan balance. Every cent counts when trying to pay off your loan.’’ He says some people might choose an offset or revolving credit facility.
‘‘This could be quite handy if you have savings that you were not going to put towards reducing your loan balance.
‘‘For example, if you had $100,000 in savings and a $100,000 loan facility. An offset account could save you money. The idea here being that your $100,000 stays in the savings account and earns no interest.
‘‘The $100,000 loan that you have is charged no interest.
‘‘Effectively any repayment that you were making to that loan would be principal reducing. Therefore you are saving interest daily. The other thing to note is that when you earn interest on savings, you pay tax on the interest. When you are earning interest at say .05% less tax and you are paying interest of 5.39%, it is a fairly easy decision.’’
‘‘Every cent counts when trying to pay off your loan.’’
Glen McLeod is director of Edge Mortgages. He is answering readers’ questions about home loans, whether you are a firsttimer just getting into the market or someone who already has a loan and is wondering about the best way to manage it. If you have a query, email susan. edmunds@stuff.co.nz