Lending conditions are in a pretty unique place right now. As can be seen in the graph below, interest rates in Australia haven’t been this low in decades.1 In fact, we haven’t seen rates like these since the 1950s.
Rates were already reaching record lows when the cash rate hit 2.75 per cent in May 2013. It then spent almost three years at a low of 1.5 per cent from August 2016. Now the cash rate has dropped to 1 per cent, and many economists are predicting yet another rate cut – or even two – later this year and early next year.2
While this is all pretty bad news for savers, Barefoot Investor Scott Pape says this is an exceptional opportunity for borrowers, particularly as many Australians have huge amounts of debt.3
The graph below shows how our debt levels have risen over the same 30-year period. Household and mortgage debt are now close to the highest they have ever been.4
What should borrowers be doing?
While it’s always nice to see smaller loan repayments coming out of your account, Pape reminds us to look towards the future.
He reminded Australians not to be complacent and expect that the low-interest rates will be around forever. Borrowers should make the most of the gift they’ve been given and start paying off their loans in earnest.
Getting ahead on your mortgage
The more quickly you pay off any loan – whether it’s a mortgage, investment loan or another type of loan – the less you will pay overall since the total amount of interest you have to pay will be reduced.
So, if you want to get ahead on your mortgage, you could start by continuing to make your repayments at pre-cut levels.
A recent analysis by comparison website www.finder.com.au found that a homeowner with an average mortgage of around $400,000 would be paying around $120 per month less after the two rate cuts. But if the homeowner maintains their repayment amount, effectively making an extra monthly repayment of $120 on the new rate, they would save $40,300 in interest and reduce their loan period by 39 months.6
For some borrowers, years of low-interest rates may have left them with some extra fat in their budget. If your finances allow, Smartline CEO Sam Boer suggests borrowers consider increasing their repayments by a small percentage each year to really make a dent in their loan balance.
In the example above, let’s say our homeowner decides to keep their repayments at pre-cut levels by making an extra repayment of $120 per month. If over the next 12 months, they opt to increase this extra repayment by $50 per month (i.e., an increase of 2.5 per cent on the minimum repayment), they stand to save just over $54,000 in interest and shave almost four and a half years of their loan term. If they have the means to continue to increase their repayments gradually (perhaps by around 2.5 per cent each year), the savings will compound to significantly reduce the overall debt.7
Alternatively, homeowners can make additional lump sum repayments. While many borrowers ‘plan to’ make a lump sum contribution at some point in the future, it’s important to know that the sooner you do this, the more you will save.
For example, a once-off $10,000 lump sum repayment in year three of our $400,000 mortgage saves the homeowner $21,931 and reduces the loan period by 15 months. By comparison, the same lump sum payment in year 10 of the loan saves the homeowner just $13,643 and reduces the loan period by 11 months.8
I can help you crunch the numbers and determine if you can afford to increase your repayments – and if so, by how much. I can also discuss with you whether a lump sum contribution would be a more suitable option. Either way, if you can afford to pay down your debt now, you will reap the benefits down the track. In other words, ‘make hay while the sun shines’, as a wise person once said!
SOURCES: 1https://www.rba.gov.au/statistics/cash-rate/, 2https://www.businessinsider.com.au/the-chances-that-the-rba-will-cut-interest-rates-in-australia-on-tuesday-are-increasing-as-a-trade-war-resolution-grows-distant-2019-8, 3https://www.news.com.au/finance/economy/interest-rates/barefoot-investor-scott-pape-urges-homeowners-to-focus-on-paying-down-their-debt/news-story/3215f4ef9feeddbaf5b14aec62d73b6a, 4https://www.macrobusiness.com.au/2019/07/rise-rise-australian-household-debt-2/, 5https://www.news.com.au/finance/economy/interest-rates/barefoot-investor-scott-pape-urges-homeowners-to-focus-on-paying-down-their-debt/news-story/3215f4ef9feeddbaf5b14aec62d73b6a, 6Assumes an initial average variable rate of 4.91 per cent and a subsequent rate of 4.41 per cent (after the RBA’s rate cut of 50 basis points) https://www.finder.com.au/press-release-june-2019-40k-home-loan-hack-why-borrowers-should-keep-their-repayments-on-hold, 7https://www.finder.com.au/extra-loan-payments-calculator, 8https://www.finder.com.au/lump-sum-calculator