Provided by Mercer: 25/11/09
Ever dreamt about a rich, long-lost relative who passes on and leaves you their vast personal fortune? Well you are not alone. We’ve all delved into the world of fantasy at times to escape from the very real pressures of financial responsibility. Sadly, such fantasies aren’t likely to bring financial success.
In fact, most Australians have to borrow money from a bank or financial institution to help achieve various goals. These goals might include travel, a car or home, or various types of investments such as shares. Fortunately, in 2009, loan interest rates have been reasonably low, making repayments easier for most people.
The danger of affordable repayments can be that it may be easy to forget the impact of the interest your loan is accruing. For example, a home loan of $350,000 taken over 30 years at an interest rate of 7.79% could end up costing you close to three times that – $910,465 in total1 – over the course of the loan. If you make your repayments automatically, via direct debit to your loan account, it is very easy to forget the real price you’re paying.
Credit cards are another common pitfall. Those few purchases at the shops totalling $500 today could translate to almost double that ($954), if you only pay the minimum monthly payment at, for example, an 18.5% annual interest rate over time2.
But it’s not all doom and gloom. Loans are a not-always-pleasant necessity, but if approached as a form of savings, you may potentially save yourself a substantial amount of money and achieve your financial goals sooner.
An extra payment now = big saving over time
If you have some extra cash in your budget, it could be tempting to save your windfall in a high interest savings account or term deposit. Although this can provide a feeling of security and comfort, let’s explore how this would compare over the longer term if you paid this on your loan instead:
Case study one – put it in the bank
Deb receives an annual bonus from her employer valued at $5,000 (after tax). She considers starting a ‘rainy day’, internet-based, high interest saver account. Deb’s bank pays a rate of 5.0% on this account, and interest is compounded once each year.
After 30 years, Deb’s $5,000 will have grown to over $21,609.71. This assumes Deb makes no further payments to her initial $5,000 investment; that the interest rate stays at 5.0%; and does not take into account any fees, charges or tax.
Case study two – put it on the mortgage
Deb rethinks her plans for her $5,000. She doesn’t think $5,000 will impact her $250,000 mortgage much, but decides to work out what impact it would make on the interest she would pay over time.
Deb is surprised to find out that by paying the $5,000 as an additional, lump sum payment on her loan, she would reduce her 30-year loan term by 1.5 years, and save a whopping $27,919.30 in interest3 over that period!
Not only is Deb $6,000 better off in this example, but she’s reduced her loan term in the process – earning valuable extra time to accumulate extra savings.
Depending on your personal situation, one of the most effective savings strategies you can consider may be to pay off your loan(s) as quickly as possible. You may be fortunate like Deb and have the occasional lump sum to use. But if your budget is already tight, there may be other strategies that can still help you chip away at your loan and still save a considerable amount of interest over time.
Other ways to reduce your debt
- Switch to fortnightly instead of monthly repayments. How it works is that you pay half your standard monthly payment each fortnight which works out to cover one extra monthly payment each year. This will mean a small impact in the short-term (you will pay slightly more each year overall), but over the course of your loan, fortnightly repayments will knock off both interest and time.
- Consider a mortgage offset account. Money in this type of account is ‘offset’ against your mortgage, and you pay interest only on the remaining mortgage balance. For example, if you have a mortgage offset account balance of $15,000 and have a mortgage of $200,000, you will only pay interest on $185,000 (200,000 – 15,000) when it is calculated. Some mortgage offset account holders direct their salary and other savings into these accounts and treat it as a primary savings account. This may be an effective strategy if you still need your money on-call, rather than locking it away as a mortgage payment.
- Consolidate your loans and credit cards. Every loan brings its own fees and interest, and it doesn’t make sense to pay more than lender if you don’t have to. Many financial institutions offer ‘loan consolidation’ products, which effectively mean that they will pay your debtors and roll multiple loans into one, so that you are paying only one set of repayments and fees. Lenders can charge quite varied interest rates and fees for these products, so shop around for a competitive deal. And limit your credit card to one if it is practical for you to do so.
Get advice
If you have any questions about your personal situation, a licensed or appropriately authorised financial adviser can help you work out a strategy that suits your income, debts and long-term goals. Mercer has a dedicated team of professional financial advisers who can help you make the most of your finances. You can speak directly to a Mercer financial adviser on the phone, or make an appointment for a face-to-face consultation by calling 1800 633 403.
1 au.pfinance.yahoo.com, 27-10-09
2 infochoice.com.au, 27-10-09
3 resi.com.au, 27-10-09
This information has been prepared by Mercer (Australia) Pty Ltd ABN 32 005 315 917 for general information only. The information does not take into account your personal objectives, financial situation or needs. Therefore, you should not act on this information if you have not considered the appropriateness of this information to your personal objectives, financial situation and needs. You should consult a licensed or appropriately authorised financial adviser before making any investment decision.
