Homeowners had been expecting a big hike in interest rates on Wednesday but the Reserve Bank kept the Official Cash Rate (OCR) on hold at 0.25% in response to the new outbreak of Covid-19 in New Zealand.
However, in its Monetary Policy Statement on Wednesday, the Bank warned that house prices were above sustainable levels, a clear signal that the current rates reprieve is temporary.
Most economists expect that the OCR, which determines mortgage interest rates, will be substantially raised by the end of the year, predicting that once the Covid-19 outbreak has settled down homeowners should expect to see a series of hikes that could add up to 2.5% to mortgage interest rates.
So how can homeowners use the small window of opportunity to reduce their mortgage when interest rates are still at record lows?
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Some people really smash their mortgages, and it’s not uncommon to hear of homeowners who have paid off a 30-year mortgage in 15 years.
Let’s look at a $500,000 mortgage at 4% interest, remembering that this could rise over time. The different scenarios show:
Reducing the term
Impatience pays with mortgages. Reducing the term from say 30 to 25 or even 15 saves considerable sums of money.
• 30-year term: The cost in total over 30 years of the $500,000 mortgage is $859,348, including interest of $359,348.
• 25-year term: Over the 25 years the total cost is $791,755 including interest of $291,755, saving a total of $67,593.
• 15-year term: The total over 15 years adds up to $665,719 with interest of $165,719, saving a staggering $193,619 compared to 30 years. Monthly repayments are $3,698.
Making extra payments
Some homeowners choose to have a longer mortgage term but pay it off faster by making additional principal (capital) repayments. If life changes, they can simply revert to the standard repayment. They should always check with the lender if it’s fee-free. Sometimes borrowers have to split the mortgage between fixed and floating, maying extra repayments on the latter. Sometimes fixed mortgage conditions allow a fixed dollar amount of overpayments each year. The difference overpayments can make:
• Extra $200 per month repayments. The 30-year $500,000 mortgage will be paid off in 25 years saving $55,912 in interest.
• Extra $1,000 per month repayments. The mortgage will be paid off in 16 years and save $169,872 in interest.
• Extra $2,000 per month repayments. It takes just 11 years to pay off and saves $229,341 in interest compared to 30 years.
Using revolving credit
Some banks offer revolving credit and other mortgage products such as BNZ’s Total Money where money in a borrower’s current and savings accounts are offset against the debt owed on the mortgage reducing the outstanding capital and thus the interest paid. Revolving credit is like a giant overdraft. When a customer’s pay is credited each month, it reduces the outstanding principal for a period of the month, trimming the interest bill.
What’s holding Kiwis back?
University of Auckland professor of experimental economics Ananish Chaudhuri says what holds borrowers back from paying their mortgage down faster is likely “present bias” . That’s the tendency to put too much weight on what is happening in the present and not enough on the future. “This is partly why we find it harder to reduce current consumption in order to save more for retirement,” says Chaudhuri. “Similar thinking applies to not paying off loans faster.
“(We) make the minimum payment we can now in order to have higher consumption now without realising that we are foregoing higher consumption in the future,” he says.
Paying the mortgage down faster means finding the funds to do so. Banks test customers on their ability to make repayments on a 6% mortgage. That means it should be possible for homeowners to increase their repayments if their personal situation hasn’t changed since the mortgage was taken out. For most people it means budgeting better.
Some homeowners get bonuses from their work or windfalls such as inheritances, which can be paid into the mortgage saving considerable sums of money.
Funnelling money from vices to the mortgage pays off handsomely. Buying five fewer $5 coffees a week adds up to $103 per month, which saves $31,299 in interest over 30 years on a $500,000 mortgage, paying it off three years faster. Most households could cut out many more vices.
Paying the mortgage down faster is as much a psychological decision as a financial one. Chaudhuri saw it personally when he had a mortgage with ASB.
“They actually had a tool, where you could play around with repayments. At any given fixed interest rate, they give you a choice of making the minimum monthly payment, but they also showed you how much more you could choose to repay up to a limit and how much you can save over the course of the loan by increasing your payment,” he says.
“I found that tool really useful and usually tried to go the maximum of the allowable payments in order to save on interest cost further down the road.”
