When speaking to clients about their finances, we often discuss strategies for effective debt management. A recent study found that Australian Household Debt to Income levels, have tripled since 1990. Australians are spending more of their income to service their debts than ever before. This is a concern given we have a historically low RBA cash rate.
Our record borrowings don't end at home loans. Aussies are also racking up substantial debt on their credit cards and personal loans. It is not uncommon for individuals to have total borrowings which are a combination of more than one type of debt. If you have any debt at all, no matter why or how you borrowed, it's always a good idea to make extra loan repayments.
Why Are Extra Loan Payments Always a Good Idea?
Every dollar you owe on your debts is costing you monthly interest. It could be as little as 4.17% on a home loan, or as high as 30% on a credit card. Making extra payments gets you out of debt faster and saves you money. This is an opinion shared by ASIC's MoneySmart
Thanks to the impact of compound interest, any extra money you pay off your debt today, will continue to save you interest for the remaining life of your loan. Extra loan repayments are beneficial for two reasons:
1. The Interest Charged on Loans is Higher than the Interest Paid on Savings
If you have a make a lump sum payment on your credit card debt, you can save yourself anywhere from 9% to 30%, depending on what card you have. These rates are substantially higher than what you could earn on any savings account
2. You Won't Have to Pay Tax on Interest You Save Yourself
If you have money in a savings account, you will earn interest. This interest is added to your assessable taxable income. This means that you will pay tax on interest you earn. If you use the same money to pay down your loan, you will not pay any extra tax for all the future interest you save yourself. The after tax difference between lump sum savings and loan repayments is shown below:
The above example was from our post What is a Mortgage Offset Account, but the same benefits can be achieved if you make an additional lump sum payment to your loan. In our hypothetic example, putting an extra $10,000 in your mortgage will leave you $300 better off than putting the same money in a savings account.
How Much Will I Save Over the Life of My Loan?
To illustrate how much a lump sum can save you over the life of your loan, we have created a simplified hypothetic example shown below:
For simplicity, we assumed that interest rates are stable for the life of the loan, and that this one lump sum is the only additional repayment made. In this case, putting an extra $10,000 in a 4.20% mortgage for $315,000, will get us out of debt two years faster, and save us over $33,000 in total loan repayments.
What if I Also Increase my Monthly Payment?
Increasing your monthly payment, even by a small amount, can have a profound impact on your loan. You will notice that because of monthly interest charges, your monthly loan balance decreases by less than your monthly repayment. Making extra payments will help you reduce your balance faster. Any extra payments you make, will decrease your loan balance.
As we can see, the total combined benefits are that you will pay off the mortgage 5 years faster and save over $59,000 in total loan repayments. Increasing your payment by $100 per month will take an exrtra 3 years and over $26,000 of repayments off this mortgage.
How Much Can Extra Payments Save me on my Credit Card?
An Australian Credit Card statement looks something like this:
The statement shows that making the minimum payment will keep this person in debt for over 20 years. Increasing this payment by $240.70 will clear the card in two years, and save close to $8,000 in credit card interest. This is assuming that no new purchases are made with this card.
A Warning on Credit Cards:
The minimum payment on credit cards will decrease as your balance goes down. It is designed so that most of your repayment every month will only go toward paying interest. Only making the minimum payment will keep you in debt for decades
I Have More Than One Loan, Which One Should I Pay First?
Not all loans will allow extra repayments. For example fixed rate home loans and personal loans, do not always allow additional repayments. If they do, there could be fees or limits to how much extra you can repay. The first step is to find out which of your loans give you the freedom to make extra payments without limits or penalties.
If you have more than debt, pay off the one with the highest interest rate first. The higher the rate, the more expensive the debt is to you. Getting rid of the most expensive loan should be your priority.
Consolidate Your Debts
If you have multiple loans at different rates, you might have the option to consolidate all your debt to the lowest possible interest rate. After consolidation you will only have one repayment to manage, and you will save money by reducing your effective interest rate. This is illustrated below:
In the above example, our client had a car loan, a credit card and a line of credit which he consolidated into his mortgage. By doing this, he reduced his effective rate by 0.93% and saved $2,579 in Annual Interest
What About an Emergency Cash Reserve
Life is full of unexpected expenses, you never know when you'll need a little extra cash. It's a good idea to have funds set aside just for these little 'surprises'. We think your loan is a good place to keep your emergency cash. If structured correctly, your mortgage can act as a cash reserve. The simplest way to do this is through a mortgage offset account.
If you don't have a mortgage offset account, most variable home loans in Australia, offer what is known as a redraw facility. Once you have made extra repayments, the bank will let you withdraw any amount above the minimum payment. This means while you don't need the funds, you are minimizing your loan interest. If something comes up, the money is available when you need it.
A credit card can be used in place of a cash reserve, but using a credit card requires self discipline. Credit cards have the highest interest rates, and should be paid off as a priority. If have credit card debt, and want to build an emergency reserve, we recommend gradually reducing your limit. Leave yourself enough to cover emergency expenses, but focus on paying down the balance, and bringing the limit down.
Our Closing Word
Debt has become a necessary part of our financial lives. We want things now, not later. We'd rather take out a loan so we can have that new car today. Savings is less fun than having a big tv or going on a nice trip.
We are no different here at The Finance Guy, there is no shortage of debt, some of which has been used for less than responsible reasons. We understand that debt is just part of life these days, but we want you to understand the costs of borrowing and the benefits of early loan repayment.
What are you thoughts about debt management? We'd love to hear from you in our comments section. We appreciate all comments and feedback.