Managing your home loan to get ahead.

Hi, thanks for watching our video about ‘Managing your home loan’ brought to you by the Davidson Institute. This video is about looking at our financial journey and thinking about how we manage our finances to use our home to get ahead financially.

Before I get started though, I need to let you know that this presentation is general in nature and has been prepared without taking your objectives, needs and overall financial situation into account. For this reason, you should consider the appropriateness of the information to your own circumstances and, if necessary, seek appropriate professional advice.

We all want to ‘get ahead’ financially and I think the best way to do that is to understand how our finances change throughout our life and to be able to effectively plan for the future that we want. So, let’s have a look at a typical financial lifecycle, with all its ups and downs.

In the early years as we are starting out on our financial journey, we are increasing our income and assets with our first job, buying a car etc. During this time, it’s important to start developing good money habits.

As our working life continues and we start to establish long term relationships and take on long term commitments our wealth tends to fluctuate depending on career and life events that contribute to, or use up, our cash flow. While we are getting established and starting to create some long-term wealth, we need to have a focus on saving to ensure our commitments can be met.

The next stage of our financial journey is where we are building and optimising our wealth as we are preparing ourselves for life after work … more specifically, life after we stop earning an income! And during this time there are lots of different events that are going to take place … like putting the children through school, perhaps buying an investment property, there may be changes to the family situation, and then as our children move out of home we may need to help them financially as well

But of course, throughout this time, for our own personal situation, it is about maximising our wealth as this is what’s going to sustain us during our retirement.

Then, of course, comes the day when we finish work and life changes significantly. At this point, if we want to do all those things that we have saved for and built up our wealth for … if we want to travel or do community work or simply spend more time with the grandkids … we still need to manage our wealth and the income from it to ensure it lasts our lifetime.

This presentation focusses on one of the most significant financial decisions many people will make … to buy a home. This commitment will often last most of our working life as we are establishing, creating, building and optimising our wealth, but by managing the debt that often comes with it and understanding how to use the equity we build up in our home, we are better placed to make the most of the opportunities it creates.

Today we are going to explore ways to manage the debt that often comes with buying a home – covering interest rates, repayments, and offset accounts. Then we’ll delve into how we can leverage the value in our home and use equity to improve our financial position and lifestyle.

So, let’s start by looking at some ways to manage the debt many of us have against our home. There are 3 key elements that we can use to reduce the cost of home loan debt. • Interest rates • Repayments, and • Offset accounts. Let’s explore each of those in more detail.

Firstly, interest rates. Getting the lowest rate possible isn’t always the best scenario as we need to look at what we might be missing out on to get that lower rate. For example, other benefits such as the ability to pay more frequently. That said, it is worth exploring whether taking up a honeymoon rate at the beginning of a loan might be helpful in getting ahead. Be wary though of restrictions or other costs following on from the honeymoon period.

Many lenders now offer packages, such as a bundle of products, with discounted rates that attract an annual fee, like Westpac’s Premier Advantage Package. Do the sums and check whether the discounts outweigh the cost of the package because these discounted rates can be a great way to reduce the cost of your loan in the long run.

Finally, let’s look into fixed and variable rates. This is probably one of these most asked questions when it comes to home finance, “Should I go fixed or variable rate?” Let’s start with ‘What’s the difference’?

As their names suggest, variable rates will fluctuate over time. Fixed rates, on the other hand, are fixed for a specified period of time. This has the effect that repayments are also fixed for that period of time, making it easier to budget and manage your cash flow. However, because your rate and repayments are set at a specific level you are generally not able to make higher repayments than those agreed without incurring a penalty.

Locking into a fixed rate also means that if variable rates fall, you don’t get the advantage of the reduced rate. Variable rates, on the other hand, while it may mean that your repayments can increase or decrease, because you are not locked into a set repayment amount, as long as you pay the minimum required you can set your repayments to suit your situation – making extra repayments when you have the money available.

There are advantages and disadvantages to each, and it depends on what’s happening in the economy generally and your personal situation at that particular point in time, as to which is the best option for you. In a bid to take advantage of the best of both worlds, many people now have split loans with a variable portion and a fixed portion.

Let’s say we have a $400,000 home loan; this could be split into 2 loans of $200,000 each – one fixed and one variable. We’d then be able to make extra repayments on the variable portion or use an offset account to reduce the cost of this loan. However, on the fixed portion, we can be certain both the rate and repayments won’t change during the fixed term.

In the example on the screen, I’ve used Westpac’s mortgage repayment calculator to demonstrate the difference. The monthly repayments on a home loan of $400,000 repaid monthly over 30 years, at the variable rate of 8.00%pa would be approximately $2,940 per month.

By making repayments of ½ the monthly repayment, that is $1,470 on a fortnightly basis, we can significantly reduce the overall term of the loan and the interest costs. On this repayment amount and frequency, you could potentially shave 7 years off the loan and save nearly $190,000 in interest costs.

The time and interest savings are generated because the more frequent repayments reduce the principal amount more quickly, which reduces the amount of interest to be paid. There’s also the fact that there are 26 fortnights in a year and only 12 months in a year so you effectively get an additional repayment each year as well.

Another option for some is to make repayments higher than the minimum required amount. Again, this has the effect of reducing the principal more quickly, and thus the interest calculated too.

The example on the screen shows the same loan amount of $400,000, at the interest rate of 8.00%, with repayments of $2,936 per month over 30 years. Let’s bump that up to $3,000 a month, that is an additional $64 a month. Again, the savings in terms of time and interest are significant. If you’re able to squeeze some extra repayments out of your budget, it’s well worth it in the long run.

If you’re going to make additional repayments though, check whether your loan has a “redraw” facility that will allow you to retrieve those extra repayments should you need to. Remember too though, that if you decide to fix your interest rate, you may not be able to make more frequent or additional repayments without incurring penalties. Make sure you check before changing your repayment arrangements.

That then leaves an Offset account as the final element to help manage your home loan costs. So, what is an offset account, how does it work and what’s the benefit of using an offset account? Essentially, an offset account is a savings account that is linked to a variable rate home loan, and the balances are netted against each other. The home loan interest is calculated on the netted balance.

Following on from our previous example where we had a $200,000 variable rate home loan, let’s say we also have a savings account with $25,000 in savings. When netted against the $200,000 variable rate home loan, interest is calculated on the net balance of $175,000.

For this example, to keep things simple I’m going to assume no changes in the interest rates over the loan term. If we had simply put the $25,000 savings in an account that earned 2.5% interest per annum and we left the interest in the account to accumulate, then after 30 years, using the Moneysmart compound interest online calculator, we would have earned $27,884 in interest.

This is due to compound interest. So, in year 1 the bank pays you interest on the $25,000. If we leave this interest in the account, the bank will then pay interest on the new higher balance. So, each year, assuming there are no withdrawals, the account balance will increase and the account will earn more interest each year on the increasing balance.

On the home loan, if we simply made the minimum monthly repayments, then using the Westpac Mortgage Repayment online calculator, at a rate of 8.00% per annum, we would pay $328,310 in interest over 30 years. So, the net amount of interest paid over the 30 years would be $300,426. The $328 thousand paid on the home loan, less approximately $28 thousand received on the deposit.

If instead, we held the $25,000 savings in an offset account linked to the $200,000 home loan, made the minimum monthly repayments only, and there were no interest rate changes, with the interest being calculated on the netted balance then using the Westpac online Home Loan Offset Calculator the term would reduce to 21 years 4 months, and we would pay roughly $175 thousand in interest. Compared to the previous scenario in which $328 thousand was paid, this is a saving of over $150,000.

These figures are calculated using a 100% offset, which is what the Westpac home loan offers. You can see there are significant benefits that can be gained by using that feature. Check with your lender whether they offer a 100% offset.

Another great thing about these offset accounts is that they generally operate in exactly the same way as a normal transaction account. With most mainstream lenders, you can have your pay directed there and link up your access card, arrange direct debits, pay bills and so on. There is no need for another separate account, and all your money is working for you, reducing the cost of your home loan.

If you are a disciplined spender, you could also add a credit card with an interest free period into the mix. By using the card for all your regular expenses and clearing it in full once a month from the offset account, your regular bill money is also working for you in reducing the cost of your home loan.

So, there we’ve explored a few ways that you can save some money on your home loan through seeking out rate discounts, mixing fixed and variable rates, making more frequent or additional repayments, and using an offset account. Let’s have a look now at how we can use the equity building in our home to earn more wealth for us instead of simply being a drain on our cash flow.

In theory, two very specific things happen with our home over time. Firstly, the value of the property itself generally increases. Secondly, we repay the home loan. As time progresses, the gap between how much the property is worth, and how much we owe on the home loan, increases. This is known as your equity. Many homeowners are already increasing the size of that gap by using some of the tactics we’ve just looked at like offset accounts, accelerated repayments and so on.

However not everyone is using that gap to their advantage.

That’s what we are going to explore a little further because it’s no great secret it’s just about having a little more knowledge and the mindset of planning for a better financial future. So, let’s apply some numbers to that theory to illustrate the growth in equity.

Let’s say we have a property currently worth $400,000, property values in the area are growing at 4%pa, and the loan for the property is being repaid at the minimum monthly repayment over 30 years. So, on these assumptions, after 30 years, the property will be worth $1.2m and there’ll be nothing owing on it. From a banking perspective this equity is valued at 80%, meaning that the equity in the property is $960,000.

But that’s in 30 years’ time. What if you want to access some of that equity sooner? Throughout the life of the loan, there is an ever-increasing amount of equity available. So, based on our assumptions of 4% annual growth in property value, minimum monthly repayments being made on the home loan, and that equity is valued at 80%, let’s have a look at the equity as it builds.

After 3 years, there’s approximately $50,000 in available equity. After 7 years, there’s approximately $130,000 in available equity, and after 15 years, $475,000. Let’s now overlay this diagram with our financial lifecycle segments. For most people, the segments that are relevant will be creating, building, and optimising wealth. This is where our planning for how we can use the equity, or leverage the equity in our home, can now kick in.

By considering what the likely events may be that will occur throughout the asset’s lifecycle, we can gain an understanding of approximately when you are likely to need access to additional money. For example, we will have a rough idea of things such as marriage, travel, kids’ education and so on. Then, we can consider what potential opportunities exist to use the equity to build further wealth or enhance our lifestyle.

For example, at about 7 years maybe the children will start school which provides the option to use some of the equity built up in the home to pay for private schooling or tuition, or if you wait a little longer, say 10 years there may be enough equity to help purchase an investment property. By recognising that our home is an asset that we can use to improve life in other ways, we are then able to plan for the options that this opens up for us.

So, we started out this presentation by looking at how our finances and the way we manage them change over time. When we’re starting with all those firsts if we establish some good money habits here, they will stand us in good stead for the rest of our life.

Then we spend a number of years working. Our financial position will fluctuate throughout this time depending on how we are using our money, but we need to be conscious throughout this time of steadily building then optimising our wealth so that when we are no longer working, we have sufficient to provide for the lifestyle we want.

As we have seen today, our home can help us improve our financial situation if we’re aware of, and take advantage of, the equity we can accumulate there. I’d encourage everyone to take a look at where you are currently on this cycle and to consider what actions you are currently taking, think about what you have coming up, and whether you need to change anything. It’s through actively planning, and using the tools we have available, that we can work towards the financial future we want.

During this presentation we have looked at some techniques to manage your home loan and reduce the costs. We also looked at using the equity in your home to generate more wealth or enhance your lifestyle, helping you to plan for the financial future you want.

Thanks for watching our video on ‘Managing your home loan’. I hope you found the information helpful, and I encourage you to check out the other resources on the Davidson Institute website to help build your financial confidence. Bye for now.