You’re buying your first home. But interest rates are expected to start going up at some point. Which is the better financial strategy? Do you stretch yourself, get the biggest loan you can and buy the most expensive/biggest house you can afford? Or, do you take out a smaller loan, buy a smaller house, easily pay down the mortgage as quickly as you can, and then upgrade to a bigger house down the track?
It’s not always easy to work out what your property needs will be in the future; it may be tempting to just live in the ‘now’. But planning ahead is an essential part of taking out a loan – it really pays to have a clear and financially sensible plan in mind.
Let’s assume a 7-year plan. From Graph 1 below, we can see that purchasing a more expensive house should generate greater capital growth. Assuming average capital growth of 3.5 per cent per annum, we can see that Couple 1 accrued $47,169 more in equity than Couple 2 over the period. If property values increase, a bigger purchase means your profit is maximised and you may not need to upgrade down the track, saving you stamp duty costs. However, with interest rates tipped to increase, you may risk struggling with repayments.
Another option is buying a cheaper (and probably smaller) home and paying off the mortgage more quickly.
For Graph 2, let’s assume 4 per cent interest and a loan period of 30 years. Couple 2 took out a smaller loan and made extra repayments. They reduced their mortgage balance by $51,615 more than Couple 1, who could only afford minimum repayments on their more expensive property. At this rate, Couple 2 will pay off their loan in 15.5 years, saving them $128,360 in interest.
But average interest rates are tipped to reach 5.5 per cent by 2021, so let’s examine what happens to our figures in that scenario.
Couple 2 is now $74,987 better off in terms of debt reduction than Couple 1. At this rate, Couple 2 will pay off their loan in just 14 years, saving them a massive $193,726 in interest.
As interest rates increase, being able to pay off your mortgage as quickly as possible can result in substantial savings, and may also be less risky. However, it does mean that if you need to upgrade to a larger home later, you may need to factor stamp duty into your equation.
These examples show there are a number of factors to consider when we look at the longer term financial advantages and disadvantages of your decisions. A great mortgage adviser can help you crunch the numbers for various scenarios, so you can create a mortgage plan that makes the most financial sense.