By Bhavesh Malani 



Let’s face it: no one likes being in debt, but it’s near impossible to buy a home without it. Thankfully, there are some ways you can reduce your debt burden and make you mortgage-free faster.

Why Should I Reduce My Debt When I Can Afford the Repayments Right Now?

Good question, guy who writes my headings! Here’s why you may want to reduce your debt as fast as possible:



Every loan has two components: principal (i.e. the amount you borrow) and interest (i.e. the cost of borrowing money). Most loans in New Zealand are amortized, which is a fancy way of saying the loan is broken up into small parcels, with a set repayment every month. A part of that repayment goes towards reducing your principal and the rest is comprised of interest payments, which don’t reduce the amount you owe but instead vanish into the deep, dark recesses of bank balance sheets.

Let me explain this further. Assume you have bought yourself a $1,000,000 house with a 20% deposit (yay!). That means you’ve taken an $800,000 home loan for up to 30 years. Assuming an average interest rate of 4.5% over those 30 years (based on historical rates , I’m being optimistic!), if you only made your minimum monthly repayment of $4,053.48 and nothing else, you would have paid just under $660,000 in interest alone. That $1,000,000 house is actually a $1,660,000 house! Assuming you bought this house at the age of 35, you’ll be repaying the loan until retirement.

Interest rates are low, but they are rising 

Thanks to record low interest rates, a mortgage has never been more affordable in New Zealand. In fact, the 1-year rate is so low that your interest component on the same loan would only be 48% of the total repayment in month 1.

The thing to remember here is that a mortgage is a 30 year commitment, and requires a long-term view. So let’s take a detour from home loans and do some back alley economics!

Interest rates dropped like a rock because the Reserve Bank of New Zealand (RBNZ) needed to stimulate the economy to prevent a depression in the wake of the COVID-19 pandemic. It does this by changing the Official Cash Rate (OCR), which is the base rate used to determine bank borrowing and savings costs. In a nutshell, if the economy is slowing and inflation is low, the bank reduces the OCR to make it easier for people to borrow money and boost spending and investment. If the economy is going strong and inflation is increasing towards 3%, the RBNZ will raise the OCR to make borrowing money more expensive and discourage spending. All signs now point to the sort of economic growth that hasn’t been seen since the end of World War 2, both domestically and overseas , which means that inflation - and interest rates - will probably rise appreciably in the years to come.

Interest rates are still low now, but they have already begun to rise, so it makes sense to prepare ourselves for a more expensive future by ensuring you’ve got less owing on your mortgage and less interest to pay.

So How Do I Reduce My Principal Faster?

There are 3 main strategies to achieving this. In all cases, the basic idea is to find ways to reduce the interest component on your repayments.

1.  Make Extra Repayments

Obviously, the simplest answer is to pay more than you need to. Every extra dollar goes towards reducing your principal and thus reduces the interest component on your next repayment. This strategy has a few limitations:

1.     It may not be affordable for everyone

2.     If you’re on a fixed rate loan, banks may place limits on extra repayments that can be made without incurring early repayment fees

3.     Floating rate loans have no limits on extra repayments, but the interest rates are often a lot higher than fixed rate loans, which increases the minimum monthly repayment

4.     You may not be able to redraw the extra repayments made in an emergency.

Certainly, if it’s affordable and possible to make significant extra repayments on your loan, this is the most straightforward way of paying down your loan quickly. However, there are some significant disadvantages, especially in terms of your cashflow. You wouldn’t want to put all your money into your home loan only to come up short for large, unexpected expenses. Which takes us on to our next method...

2.  Use a Revolving Credit Account

A revolving credit account is like a giant overdraft, but the key difference is that while your vanilla overdrafts are unsecured, the revolving credit facility is a loan that is secured by your property. As the bank holds an asset (your property) as a securit, the loan is classified as a lower risk and therefore attracts a lower rate of interest compared to a standard overdraft. The interest rate is not fixed and is subject to change, and is higher than fixed rates. However, this is outweighed by the significant benefits of this account:

1.     The repayments are interest-only, which increases your cash in hand every month

2.     You can deposit your savings into the revolving credit account, reducing the overall loan balance. Interest is calculated daily based on the outstanding balance, so the more money you put in, the less interest you pay. Remember, reducing interest is the name of the game!

3.     As it is a floating loan, there is no limit on how much money you can put into the revolving credit account

4.     You are able to redraw funds up to your limit to fund large expenses such as a subsequent property purchase

If you are the sort of person who can save a fair chunk of your income, it makes sense to use your savings to reduce the overall interest paid on your home loan. You can even combine this technique with the one above, by saving through the year and making a large lump sum repayment on the fixed portion of your loan, before refixing and starting again.

The main risk associated with a revolving credit lies in the ambiguity of how your account balance is preaented. Let’s say you have a $100,000 revolving credit facility, and you have saved $100,000 (go you!). Your loan is effectively paid off and you are charged no interest. When you log on to online banking, you will see you have $100,000 available to spend. What you don’t see there is that every cent you draw from that account will incur an interest charge, as you are effectively redrawing your loan. It sounds simple, but it is incredibly easy to lose track of how much you owe when you have a large revolving credit account. There are a few good strategies for avoiding these pitfalls, which I will share in a future post. Note that banks reserve the right to recall revolving credit facilities at their discretion.

It’s pretty evident from the above that revolving credit accounts may not be everyone’s cup of tea. If you’re the sort of person who wants to have a set monthly payment while also being able to use your savings to reduce your interest burden, the next account might be the one for you...

3.  Offset Account

An offset account is often confused with a revolving credit account, but there are some key differences. Firstly, while revolving credits are interest only accounts, an offset account is more like a traditional floating rate home loan with a repayment comprised of principal and interest. Revolving credits tend to be all-in-one affairs, with everything sitting in one account. Offset accounts are cleaner in that regard, with a separate account for your offset home loan, which is then linked to a number of your (or in some cases, your family’s) savings accounts. The savings balances in these accounts “offset” the amount of the loan that attracts interest. Let’s look at a couple of examples, assuming you have a $50,000 loan on a 30 year term, with an interest rate of 4.55% p.a.:

Case A - $0 savings balance: Your monthly repayment will be $254.83. As you have no savings, in your first month you pay interest on $50,000, which is $189.58, or 74.4% of your monthly repayment.

Case B - $30,000 savings balance : Your monthly repayment will still be $254.83, as this is calculated based on the total amount outstanding. Because you have saved $30,000, interest will be charged on ($50,000-$30,000) = $20,000, and so the interest component will be $75.83, or 29.8% of your monthly repayment. Calculated across your total loan of $50,000, your interest rate is effectively 1.8% p.a.!

Case C - $50,000 savings balance: As before, your monthly repayment remains unchanged at $254.83. With $50,000 saved, interest will be charged on ($50,000 - $50,000) = $0. You therefore pay no interest on this loan and every single cent of your repayment goes towards repaying your principal!

Obviously, case A isn’t ideal because you pay far too much in interest for an offset account to be worthwhile. If you’re a good saver and have some funds left over after your property purchase, you may look at starting with Case B (offset loan greater than your total savings) and saving enough every month to end up in Case C, which is where your loan is fully offset.

The great advantage of offset loans is that you save on your interest payments while keeping your savings and loan accounts separate. You can make lump sum repayments above the minimum amount and redraw them, just like you would with revolving credit. However, your linked savings accounts will not accrue interest – which hardly makes a difference as savings interest rates are near enough 0% at the time of writing. Furthermore, offset accounts are slightly more expensive than fixed rate loans and revolving credit loans, but are often more efficient than extra repayments at reducing your loan balance.

Summary

In essence, the key to paying off your loan faster lies in finding ways to reduce the interest component of your loan, whether it is by making extra repayments or using your savings to reduce the interest payable.

There is no one-size-fits-all solution, however. The right product for you depends on factors such as your risk appetite, your financial goals, your plans for the near future and how much free cashflow you have available to contribute towards the above strategies. To find out which method is best for you, call me for a free, no-obligations discussion on how you can turbocharge your home loan repayments!