By Amanda Morrall
Cast your mind back to 2007 before that three letter combination GFC was conceived and things like fiscal cliffs and debt ceilings weren't part of the daily vocabulary.
Retail investors were blissing out on double digit returns they thought would last forever, clueless about the level of associated risk, and consumers were partying more like it was 1999.
Five years on, a lot has changed, most notably for borrowers and savers -- interest rates.
Okay, so interest rates haven't fallen as hard here in New Zealand as they have elsewhere. However, the relative impact has been just as sharp. Mortgages are a case in point. First time mortgage holders on a floating rate would in January 2007 have paid an effective rate of around 9.29%. As of August, 2012, it was 5.67% - 39% lower.
You can't quite call it a free fall, as it happened gradually. To take advantage of the plunge in rates, homeowners have been madly renegotiating with their banks or else been wooed by competitors offering better deals that come with built-in payment of related break fees. You'd be a fool not to take advantage of a lower rate where possible because even a slight shift in interest rates spells big savings.
But here's a thought: What if you maintained those pre-GFC payments at the same level while taking advantage of the lower interest rate? The results just might surprise you.
Here's one example:
On a mortgage of $250,000, at a floating rate of 9.29% (which is what the effective rate was back in January 2007), your repayments would have have been around $988 per fortnight over a 25-year-period. The total interest on that works out to around $393,812. At the effective floating rate of 5.67% (which is what the Reserve Bank of New Zealand data shows for August, 2012) the repayments would be around $718 per night with total interest of $217,779.00
More is less
Here's where it gets interesting: Let's assume, with great discipline and that wage growth you would've experienced between then and now, that you'd kept your payments at the 2007 level but you took advantage of the lower effective rate of 5.67%. Not only would you knock close to 11 years off your mortgage, (reducing it from 25 years to 14) you'd also save you more than $100,000 in interest.
I think it's fair to say most home owners know they'll be better off knocking back the mortgage as fast as possible, and yet there is a big difference between knowing and doing.
John Bolton of Squirrel Mortgage Brokers said when interest rates were up at pre GFC levels many of his clients struggled to pay the bills and make their mortgage obligations. He said petrol and childcare costs were financially crucifying in many cases. When relief came in the form of lower interest rates, Bolton said many elected to use the savings on mortgage repayments to cover living expenses and make top up payments where possible.
"I''d say roughly one-third went into voluntary mortgage repayment and two-thirds living expenses. People were really struggling with high rates and living cost adjustments,"
Bolton said couples or individuals in a position to keep their payments up at 2007 levels would reap the benefits.
The following table, showing the interest saved by keeping payment levels on a mortgage of $400,000 up at the same rate determined by a 8% interest rate, (subsequently reduced by 220 basis points as we've seen) is another case in point.
|Payment amount (montly)||$2,935||$2,935||$2,347|
|Mortgage Term (years)||30||18.6||30|
|Reduction in interest||$402,245 (61%)|
In his work with clients today, Bolton said he encourages clients to fix their repayment on a rate of about 7.50% or an amortisation term of 20 years.
According to the Canadian Association of Accredited Mortgage Professionals, about 60 per cent of mortgage holders there pay the minimum mortgage payments on their house; that is they pay off the debt in the longest allowable time frame.
Personal finance trainer Hannah McQueen, of enableMe, said of the clients she deals with, around 90% fall into that minimum repayment camp; 25-year amortisations paid on a monthly or fortnightly at the prescribed repayment rate.
It's not that home buyers want to cause themselves more financial misery than necessary. It has more to do with the false assumption that that's all they can afford to pay, she said.
In her work with clients, McQueen has discovered that the road to financial freedom is a lot closer than many think.
"Typically, the reason they can't put more on the mortgage is because most people are spending everything they earn, so they're trying to minimise commitment on their mortgage.'' she said.
Much of the work McQueen and her team of personal finance trainers do relates to curbing unnecessary spending and redirecting it toward mortgage repayment.
While the financial effects are felt immediately, McQueen said it takes about a year for people to fully modify their behaviour so that the financial restructuring is sustainable.
"It’s pretty easy to go on a crash and burn financial diet but it'll affect relationships eventually. So instead we use a velvet glove approach."
Rather than coming up with extreme savings and sacrifice, the velvet glove is an a process whereby clients are forced to examine their own spending patterns with a view to determining where they can cutback here and there or else compromise.
Give and take within reason
"A lot of it is psychological,'' said McQueen. "If there is a sense that we are going to go without we tend to just jump off the wagon.''
To see the effect of repaying your mortgage at a higher amount, over a shorter period, or at a different interest rate, check out Westpac's Fine Tune My Loan calculator here.