Future Focus: The decisions that make a difference to your mortgage
The trade offs for key decisions with your mortgage.
I have spent a meaningful amount of time considering the intricacies of home loans since purchasing my home two years ago. My research has made me more confident that I can make the right decisions based on my own personal situation.
The payoff from optimising your home loan can be significant and includes reduced interest and the potential to pay off your mortgage early. The impact this can have on your finances is no surprise. Mortgages make up more than 30% of the average household’s expenses. Paying off your mortgage and removing this line item frees a large chunk of cashflow. It offers the opportunity to improve your quality of life or put the funds towards other financial goals
There are several decisions involved in crafting a home loan strategy. In this article I explore five common decisions and run through the trade-offs and maths to make the right call for your circumstances.
Variable vs fixed interest
What’s the difference?
A brief explanation of the difference between the two loan types may be helpful. A variable rate home loan means your interest rate and repayments can vary over time in response to the benchmark cash rate (the Reserve Bank of Australia rate) and lender margins. A fixed rate means your interest rate is locked in for a set term and your repayments stay the same during that period. In Australia, between 1 to 5 years is common for a fixed rate.
The main benefit of a fixed rate loan is predictability and the ability to lock in a lower rate. The benefit of a variable rate loan is flexibility and the potential for the rate to drop if interest rates fall. Variable rate loans have a few more beneficial features including the ability to make extra repayments, redraw and offset accounts. I will address those in a moment.
According to the RBA, the share of outstanding mortgages in Australia with variable rates remains notably higher than in comparable advanced economies.
Fixed-rate terms are also typically shorter comparable to countries like the U.S., where they are 20+ years.
Variable loans have been kinder to borrowers in the recent past. In tightening phases, banks have passed through less than the full cash rate increases. Between May 2022 and December 2023, the average variable new loan rate rose 0.4% less than the cash rate itself.
Currently, variable new loan owner occupier rates are in the 5.5%-6% range.
The trade off
Choosing a fixed rate loan provides certainty of loan payments but provides no benefit to you if rates fall.
With a variable rate loan, you accept the risk that rates will be higher, but you have flexibility with extra payments, redraws and offsets. You may benefit if rates fall.
You’re also able to split your loan between fixed and variable portions. T. This allows you to get all the features of a variable loan while receiving the fixed interest rate.
Below is an example analysis of the two options.
Imagine you borrow $700,000 for 30 years (principal & interest).
Option 1: Variable rate today of 5.75%
Option 2: Fixed rate for 3 years of 5.34%, then assume variable thereafter (5.75%+)
Calculate repayments:
At 5.75%, 30-year P&I repayment = $4,035 per month.
At 5.34%, same loan: $3,977 per month.
The fixed rate for those 3 years saves you about $58 a month ($696 a year) over variable.
One consideration is any additional frictional costs and the value of particular loan features. One thing to note is predicting interest rate movements is extremely difficult but the current rate environment may play a role in your decision.
Central to any decision is your ability to afford increased payments if rates rise. If you can’t a fixed loan may make more sense as a risk mitigation approach.
Think long term about the loan you select as government and bank fees add frictional costs to any changes.
If you are switching from variable to fixed, consider limits on the extra repayments that you make. If you exceed the limit, you will usually be charged an Early Payment Interest Adjustment (EPIA). If you are trying to lower your interest rate to pay off your mortgage faster, these limits might inhibit you more than enable you.
Flexibility often wins for many borrowers as a variable loan gives you the option to make extra repayments and switch strategies. If you choose a fixed rate loan, make sure that you are comfortable with the loan term and the rollover risk. Rollover risk refers to interest on the new loan being higher than the old.
Rollover risk is particularly pertinent for me as I have a good rate. I have made it a goal to reach out to my mortgage broker every 12 months to see if there’s anything better on the market. I am currently on a 5.14% principal and interest variable loan. This is better than any publicly available loan given my loan to value ratio. The best rate was 4.89% for a fixed 2-year mortgage.
Making that switch would involve paying discharge fees while taking on the risk that interest rates would rise over the next two years or remain stagnant. The loan was also with Suncorp, who only allows $500 in extra repayments each month. This is an example of the loss of flexibility over the next two years and the frictional costs to switch loans. This just wasn’t worth it for a loan which when the term ends, will roll over to another loan which is unlikely to be better than the one I’m on.
Pay off the mortgage or invest?
This is one of the most common questions we get from readers and listeners. How do they decide what proportion of their savings should go into their offset account vs. their investment accounts? As mentioned earlier, paying off a mortgage often leaves individuals with increased cashflow to contribute to other financial goals or increasing quality of life.
Your default may be to build up your offset account which means you may not consider the opportunity cost. This approach increases the portion of your net worth that is in cash – a non-performing asset. You may reduce interest, but your cash is not growing in your offset. Over time, inflation is quietly eroding the purchasing power of the cash.
While you may be saving interest, you’re also missing out on compounding investment returns that could get you to your other financial goals faster. I think this is an important point to consider. As much as holding debt gives me anxiety it would be far worse if I derailed my chance to achieve my financial goals.
As an example, consider $1 million with a $300,000 offset balance. If your loan interest is 5%, you’re saving $15,000 a year or $150,000 over ten years through the funds in your offset.
If your emergency fund needs are $100,000 that leaves $200,000 in excess funds. If you invest the money instead of keeping it in an offset account and earn a 6% annual return, the investment would grow to $358,000. Profits would be taxed based on the type of investment, but it is still a large difference.
Prevailing interest rates play a large factor in any decision as the attractiveness of an offset drops in low-interest rate environments. Offsets become more attractive for those on higher marginal tax rates.
My colleague Mark LaMonica has written about hurdle rates here. This is the rate that you would need to reach for investing to make sense over contributing more to your mortgage.
There is no guaranteed return in markets like an offset account. The trade-off between a sure thing and the potential for a better outcome makes it a difficult choice for investors. Take all your financial goals into account and what role your mortgage plays in your holistic financial picture,
The other option to concurrently saving and investing is taking a sequential approach. This often means that you miss out on compounding returns in your investments over decades. Again, the hurdle rate principle applies here.
Offset account vs redraw facility
What’s the difference?
An offset account is a bank account linked to your variable home loan. The balance in the offset reduces the loan balance that bears interest for the monthly calculation. For example, if you owe $500,000 and have $50,000 in an offset, you pay interest on a $450,000 loan balance. The funds in this bank account can be taken out at any time. It reduces the loan balance when you make extra repayments, but you still have access to the funds (depending on lender stipulations).
Both reduce interest costs, but an offset offers instant access to cash and may have minimum redraw amounts or fees. Redraw can encourage better behaviour if there are frictional costs for withdrawal and accessing your extra repayments, while offset is easier to access.
When is the best time to pay off my mortgage?
Being mortgage free provides psychological relief and more cashflow. It also provides a reduction of risk for retirees when they are living off a limited capital base. The ‘when’ to pay off your mortgage depends on your goals, age, investment horizon and market conditions.
Figure: Key factors to consider
Final thoughts
There is no ‘one size fits all’ for optimising your mortgage. The best decision will depend on your goals, income and prevailing market conditions. The goal of investing and paying of your mortgage is the same – it is opening up choices for your future. The end goal is to ensure that you are maximising your outcomes given your holistic financial situation.
Use the levers that you have with your mortgage to optimise your outcomes and pay off your mortgage sooner while building assets that contribute to other financial goals.
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