AFN Home Loan Basics - the rate is important - however!

Your mortgage – A life time burden or a tool to create wealth?
For most people the biggest single purchase they will ever make is their home. With the price of houses at an all time high, most people have borrowed over the maximum possible term in order to qualify for the largest possible loan.

How you manage your mortgage will have a huge impact on your wealth strategy. If your financial plan only focuses on “asset creation” and ignores “liability management”, it will not produce optimum results.

How much will your mortgage cost?
The average residential mortgage is approx $250,000. What are the total costs of repaying an average mortgage over differing terms? The table below shows the total payments and interest due on an AFN home loan over the three most common terms of 30, 25 & 20 years.

As you can see from the table below, a reduction of term by a period of 5 years makes a significant saving ($70,583) in the total interest repaid. If the mortgage can be repaid over 20 years instead of 30 years the interest savings are $137,269.
 

How important is the loan interest rate?
If we take the same “average loan, reduce the rate by 0.25%, and make the minimum repayments each month over the nominal 30 years term what are the results?

Loan Amount	Rate	Term (yrs)	Monthly Payment	Total Payments	Total Interest
$250,000	7.15%	30	$1,688.52	$607,866	$357,866
$250,000	7.15%	25	$1,790,94	$537,283	$287,283
$250,000	7.15%	20	$1,960.82	$470,597	$220,597

The impact of a reduced rate of 0.25% is $15,126 and is not as significant as making repayments over a shorter term. Even if the rate was 5.00% per annum fixed and you took 30 years to pay the loan off it would cost you more ($233,000+) than if you had a rate of 7.15% and paid an extra $100 per week (total interest $189,000).

What’s the impact of making a lump sum reduction?
If we return to our original loan at 7.15% (being the AFN standard variable rate) and make one lump sum reduction of $3,000 (tax refund?) in month 12. The loan will be repaid in 347 months and the total interest reduced to $327,141 – a saving of $18,612 - more than the effects of a 0.25% lower interest rate!

AFN home loans allow accelerated & lump sum repayments with 100% redraw at no cost.

Loan Amount	Rate	Term (yrs)	Monthly Payment	Total Payments	Total Interest
$250,000	6.90%	30	$1,646.50	$592,740	$342,740
$250,000	6.90%	25	$1,751.03	$525,310	$275,310
$250,000	6.90%	20	$1,923.27	$461,585	$211,585

Account Keeping and Transaction Costs can add considerably to cost
Over the last five years there has been an increasing trend towards the concept of user pays. This means that the lender passes on the costs of account maintenance and each transaction that you make. These costs are not included in the Comparison Rate and can add significantly to the “running” costs associated with a mortgage.
Most AFN clients have more than one account and some have as many as 20 free transactions per month.
 

AFN loans have no account keeping or transaction fees

Offset Accounts
An offset account is simply a savings account that is linked to your loan account. The interest earned is “offset” against the interest charged on the loan account. Offset accounts are okay if the interest earned is equal to the interest rate on your mortgage, and you have immediate access to your funds if you wish to utilise them.

The important question with offset accounts is “How is the interest credited and paid to the account?”.
 

Some offset accounts only pay interest on the minimum monthly balance – not the daily balance.

Line of Credit (LOC) Accounts
A Line of Credit account is like a credit card or personal overdraft. It has a predetermined credit limit, and you can draw down and repay as much or as little as often as you like. Most require a minimum payment each month, however, some allow the borrower to capitalise the interest due until the credit limit is reached.

LOC accounts traditionally have a cheque and /or a card facility attached.

Usually the interest rate is slightly higher than traditional home loan accounts and there may or may not be transaction costs involved.

Traditionally, LOC accounts have been the preserve of investors and the self employed. However, they are increasingly becoming a standard component of a home loan. They require discipline and may not be suitable for every one. If you’re a “spender” perhaps you should look at other options. Unless you are a share trader, in business, or an active investor you only need a relatively small LOC – say $15,000 - $25,000.

With a minimum redraw of $20 (fee free overnight on the Internet) on AFN home loan or interest only accounts, you may not need a LOC account at all.

Fixed Rates - Not Always a Winner
Fixed rates are a valuable tool in times of high interest rate volatility or if borrowers need comfort that their repayments will not exceed a specified level . They are commonly used in equipment and commercial property finance. While fixed rates will provide a level of comfort, they also have some inherent dangers.
Most of the baby boomer generation remember interest rates of 17% - 21% and shudder whenever there is mention of an interest rate increase. Over the last 10 years there have been a large number of structural reforms in the Australian economy and the chances of interest rates reaching these levels again would require an international financial disaster of significant magnitude.
The interest rate strategy adopted by the RBA means that interest rate cycles are much shorter, usually less than 18 months and less than 1% in variation.

Timing is Everything
As with everything timing is critical - the time to fix your rate is well before a rise is evident. Very few of us have the skill or the luck. Basically, if variable rates have already increased you’ve missed the boat!

The downside of fixing your loan Interest Rate
Is it real? The RBA has no control over fixed rates and they fluctuate on a daily basis according to market sentiment. Some lenders with large deposit bases can use cheap deposit funds to offer less than market rates however, what’s the real rate? We recently looked at one bank facility with a 3 year fixed rate of 6.45% - but the comparison rate was 7.02%. By the time we added on internet transactions at 50c and ATM fees of $2.50 a time, the effective rate including fees & charges was more likely 7.50%

The “sting in the tail” Some facilities with concessional (non market) fixed rates will require the borrower to move to the standard variable rate for a set period at the end of the fixed rate period or pay a penalty to compensate for the lower rate during the fixed period. Net saving - $nil.

Reduced flexibility - When you enter into a fixed rate agreement with a lender you lose a lot of flexibility with your repayments -
i) No accelerated repayments or lump sum reductions - although some facilities allow minimal reductions.
ii) No redraws.

Break Costs - If you break your fixed rate contract with the lender (by either refinance or sale of the property) and interest rates have fallen, you will be liable for a penalty to make up for the lenders’ losses on the contract. If rates have risen, you may receive a discount .

In Summary
The value of fixing the rate on your home loan is at best 50/50 when the short rate cycle, a relatively small increase in rates and the downside risks are taken into account. There is a good chance that you could end up losing rather than winning.

Beating the Loan Repayment Blues
Active Management - Not Interest Rate
From the examples above we can see that reducing the amount of interest payable on your mortgage is not so much dependent on the loan interest rate but on how you manage your loan. It is important that, firstly, you have a clear and simple strategy and, secondly, that you actively manage your loans to produce the result you want.

Taking the first step
The first step is to sit down with all your loan statements and genuinely assess how effectively you are managing your loans in relation to your time of life and your wealth creation plan. Determine where savings can be made in your expenditure, and how much you can afford to repay on your borrowings. Every additional dollar you can repay – even for 30 days saves you money. Set small goals - don’t try the impossible.

Budget & Discipline
Many people have problems finding the extra money to pay off their loans – there is only one solution – a budget. It’s hard work and it’s even harder to stick to it. However, a written budget will show you where you are spending your money. It’s time to be brutally honest with yourself, you’re the only winner - or loser!

Credit Cards & Store Accounts
The effective rate on these facilities is 16-23% per annum. If you make a purchase and repay them within the interest free period you are using them correctly. If not, you have a problem. These are your first priority.

Equity Mate or “Never - Never” Mate!
There is nothing wrong with using the equity in your home for consumer type purposes such as an overseas holiday or to purchase a car – as long as you repay the amount over a shorter period.
If you buy a car for $35,000 using your home loan – repay that additional amount over 5 -7 years as a maximum. It’s only cheaper if the total amount of interest is less than that payable for a car loan. It also makes little sense to pay off a 2 week overseas holiday over 30 years - a very expensive holiday!
Use the equity in your home wisely. Repay as much as possible as quickly as possible.

Minimum Committed Repayments – Maximum Flexibility – with Self Discipline
If you commit to repaying your loan over a short period at the time of application there is a risk that you will lose the flexibility of adjusting your repayments if your financial situation changes for the worse.
Rather than commit to repaying your loan over 20 years, take out the loan over a longer period and adjust the payments as if the loan was for a shorter period. If your circumstances change it is simply a matter of reducing your repayments to the minimum for a period.
If you are currently in your late forties or fifties, the time available for repayment is rapidly becoming shorter. Now is the time to review your repayment structure. Don’t rely on asset sales. Taking a little pain now is preferable to a lot when you retire.

Have a Cash Reserve
If the equity in your property is sufficient we recommend that you have a cash reserve for emergency use. This is particularly important for self employed borrowers and investors. The amount that you need will vary with your individual circumstances. LOC accounts are ideal for this purpose, as they provide quick access to funds, and you only pay interest on the funds that you draw down.

Good Accounting - Pay off Non-Deductible loans first
Many of us use our home as equity for investment and business loans. Keep life simple, have separate loan accounts for deductible (business and investment use) and non deductible or personal use. This will make life easier for your accountant at tax time. If you have an investment or business loan, pay off your home loan first. Keep your deductions as long as possible, and pour any surplus funds into your non deductible home loan.

Use your Home Loan as a Savings Account - Make every cent work for you, not for a bank
If you have surplus cash, deposit it into your home loan or line of credit. It is the equivalent of earning 7% (approx) on your funds rather than a savings account that pays next to no interest. If your loan doesn’t put you in control, perhaps its time to look at your options.