With discussion of further rate increases on the horizon, we know many homeowners are asking:
Should I stash cash in savings, or smash down my home loan balance?
So, what *is* the best approach?
Should you be striving to pay your loan off faster?
Or should you build up cash reserves to provide a buffer for potentially higher interest rates and loan repayments?
What are some other things you may want to consider here?
Why should you pay your loan off faster anyway?
You save money
To put it simply, the longer you have your loan, the more interest you pay. We all know this.
But somehow, many of us have become comfortable with just making the minimum repayment each month, having our loans for far longer than necessary. In doing this, we’re handing over thousands more to the lenders than we need to.
Every extra dollar you pay into your home loan knocks down your loan balance straight away. This means you’ll pay less interest next month. Your regular repayment amount will stay the same, but because your loan balance has reduced, more of your next monthly repayment will go towards paying off the principal, instead interest charges.
Over time, that snowball effect really kicks in… you save more in interest than earn if your money was parked elsewhere, and you edge closer to being debt-free.
Now, for those with an offset account linked to your home loan, paying extra funds into your loan account has the exact same interest savings effect as keeping this cash in your offset account. This is because when you have an offset account, the lender charges you interest on the net debt you owe them (i.e. the balance of your home loan less the funds you have in offset).
(For a refresher on how offset accounts work, read this.)
Building equity opens doors
Paying down your loan faster helps you to increase the available equity in your home (this assumes your property stays the same or increases in value, whilst your loan balance is falling).
More equity generally equates to more options — like refinancing to a better interest rate or being able to leverage this equity to help purchase an investment property for example.
Other things to consider when paying down your home loan
Shouldn’t I use extra cash for investing, rather than paying off my home loan faster?
Some will recommend you use extra cash to pay off your home loan first. Some will recommend you use the extra cash to boost your super contributions. Others will suggest you invest in the stock market instead. And then there’s those who recommend you do all these things at the same time!
The most suitable option for you typically depends on your personal goals, risk appetite and investing time horizon (e.g. how long you may have until you wish to retire). Only you will know what’s the right option for you and your family.
And in the meantime, until you decide what that is, building up cash (in your offset account) isn’t a bad idea. The cash can be used for whatever you wish, whenever you wish. But whilst you’re still deciding, this cash is reducing your home loan interest costs.
Will paying my loan down fast have longer term implications if I decide to turn this into an investment property down the track?
Short answer: yes.
If you aggressively pay your home loan down whilst you’re living in the property, and then decide to rent this property out later on , you may inadvertently reduce future interest deductions associated with this investment property.
For a little more about is, go here.
We encourage you to speak to an accountant about this, because sometimes paying off your loan fast is not the most suitable strategy. It really depends on what your longer term plans are.
It’s great I’m saving interest by paying extra into my loan and/or building cash in my offset, but I really want to reduce my repayments.
No problems, you can do this a few ways.
1. First option – reduce limit, recalibrate repayments
Say you have a $500k loan and $50k available.
First step is to pay the $50k into your loan account directly, making $50k in additional repayments. Providing redraw is set up on your loan, this $50k would be available for you to redraw back out, any time you want. Your repayments would not change. Repayments would be based on a loan limit of $500k, but interest is being charged on $450k.
Second step is to lodge a request with your lender to officially reduce your loan limit down to $450k and recalibrate your repayments based on this lower loan limit. This forfeits the $50k cash in redraw, but reduces your repayments– as they’re now based on a limit of $450k. Interest is still charged on $450k.
2. Second option – refinance your loan and reset the loan term
Say you have a $500k loan with 27 years left to go. You’re making P/I monthly repayments of $3,011.
By refinancing this $500k loan and resetting the loan term back to 30 years, you’ll give yourself an extra 3 years to pay back the loan. Even if you refinanced the loan at the same interest rate (typically you’re refinancing to secure a better rate), resetting the term in this scenario would reduce your monthly repayments to $2,886.
If you’re struggling to cover repayments and costs of living pressures, resetting the loan term can help to ease the monthly cashflow burden for a period of time. However, it can result in you paying more interest over the long term, so you have to use this strategy prudently. If you’re continually resetting the loan term and never making extra payments, you’ll paying far more in interest than you should and be much further away from being debt free.
If you’ve got some questions about your own situation, we’d be happy to help.
