Here are a few things that potentially can be done to reduce the anxiety and stress when looking at borrowing money or when reviewing your current arrangements
Don’t borrow the Maximum amount – most financial institutions will determine the maximum loan they will provide you, based on your income and expenses. If you do borrow this maximum amount, your loan repayments may be larger than what they need to be and you may find yourself stretched for cash on a day to day basis.
Build up a ‘Buffer’ – It is a good idea to hold a ‘cash reserve’ of some sort. You could hold your surplus cash in a regular savings account; however the interest rate you earn is usually much lower than what you would pay on your home loan. Also, every dollar in interest you earn is taxable at your marginal tax rate. Another good way to hold a cash reserve is through an Offset Account.
An Offset Account is a transaction account that is linked to your home loan and the money you deposit in it effectively offsets the part of the interest on the loan balance. For example, if you owe $400,000 on your home loan and have accumulated $50,000 in an offset account, effectively interest will be calculated on $350,000.
Let’s say you want to put $50,000 into a regular bank account, which may earn you say, 5% interest. In a year, you would earn $2,500, which would be taxable at your marginal tax rate.
Let’s say you put $50,000 in a loan offset account and the interest is 8% on your loan, and the offset account earns the equivalent 8%. This means you are saving $4,000 interest in a year, and this saving is not taxable. This is effectively like ‘earning’ the home loan interest rate tax-free.
You even have the option of getting your salary paid directly into an offset account. This can enable you to make the interest savings greater and potentially reduce the term of your loan. You still have easy access to your money in the offset account for day to day bills and other living expenses.
(Note: Please check the terms and conditions of the loan & offset account carefully as there may be some differences in how they work between the different lenders)
Fixing the Interest Rate – Fixing the rate on your home loan can provide protection against rising interest rates and provide certainty on future repayments to be made. However, the downside is there are often restrictions on making additional payments into a fixed rate loan, which would limit your capacity to build up a ‘buffer’ or pay it off sooner.
If rates go down, you stay on a higher interest rate and to convert to a variable rate or to fix at a lower rate, you would probably have to pay ‘break-costs’ which essentially are a fee or penalty for getting out of a fixed rate loan before the lock-in period or term has ended. Break-costs can be considerable so you need to understand this before you do anything.
Mortgage Protection Insurance – Many lenders offer or may require you to have this type of insurance when you take out a home loan. Basically, it covers the mortgage or the mortgage repayments (often up to a specified amount and for a particular period) if you die or become disabled or your employment ends involuntarily. You need to check carefully and understand what you are covered for. Many people mistake these as being the same as Personal Insurances (see below) but can be quite different and may not provide the peace of mind and protection people need.
Take out Personal Insurances –there are other insurances you should think about that protect you and your family and ensure the loan repayments can be met or paid off:
- Income Protection Insurance: This can replace up to 75% of your income if you are unable to work due to illness or injury. Income Protection Insurance ensures that you can continue meeting the majority of your living expenses, not just your loan repayment.
- Trauma/Critical Illness Insurance: Can help you service your loan or pay your living expenses by providing a lump sum payment when diagnosed with a specific illness.
- Total and Permanent Disability Insurance: This can help you by providing a lump sum of money to either pay down the loan, and an amount that can be drawn against to help pay for medical or living expenses if you become totally and permanently disabled.
- Life Insurance – which can be used to service or pay off your loan and provide your family with an ongoing income if you pass away.
Seek Professional Advice – As can be seen, Loans are varied and can be quite complex. Debt management is important. Ensuring that loans are structured correctly and are competitive by undertaking a regular review will make sure you understand what you have and ensures you get competitive rates and the best long term result.
At Lumen, we help many clients review and restructure mortgages. Give us a call if you haven’t reviewed your debt structures recently.