Paying off your mortgage when rates rise is a good idea. Photo/NZME
When mortgage rates go up, it makes perfect sense to double down to pay down debt faster. Crunch your mortgage like a lawyer.
With floating mortgage interest rates exceeding 7% and expected
to go higher, reducing the outstanding capital reduces bi-monthly or monthly repayments.
Don’t fall into the trap of thinking you can’t afford it. Most owners can at least afford the increases on paper. Thanks to the much-maligned Credit Agreements and Consumer Credit Act (CCCFA), banks are pretty rigorous in their assessment of what homeowners can afford to pay. Even when interest was very low, buyers were tested at rates around 7%.
Historically, the new rates are not that high. Floating interest rates were above 7% from 2004 to 2008 and reached above 10% for more than a year in 2007/2008.
The problem is that the human brain is wired with biases that make it hard to swallow the idea of rising interest rates. Ananish Chaudhuri, a professor of experimental economics at the University of Auckland, says this behavioral economics concept of current bias arises when someone taking out a 3% loan fails to consider the fact that they might increase significantly, even though he was warned. Present bias was seen in the subprime mortgage crisis in the United States during the global financial crisis (GFC), says Chaudhuri. Borrowers received low introductory mortgage rates, but lost their homes en masse when those rates rose to the levels they had been warned about.
Don’t let this prejudice get the better of you. Rather than “I can’t”, try: “How can I make this work?”. An extra $200 per week paid on the mortgage adds up to $10,400 per year. At 6%, every $10,000 paid off on the mortgage represents a savings of $60 per month, according to mortgage consultant (broker) Lisa Meredith of Loan Market.
Breaking the mortgage requires good budgeting and an honest look at needs and wants. Can you play yourself to reduce unnecessary expenses? Paying off debts quickly can be very satisfying.
Earning more is also very useful when paying extra on the mortgage. This may mean focusing on getting a raise or a side income. If a little person has joined the family and one member of the couple has stopped working, can that partner get a part-time job after hours when the other is at home? It’s hard, but a lot of people do it to make ends meet or get ahead.
However you find the extra cash, take a few tips to make the most of it. Meredith recommended that customers who still have low fixed rates start paying at the higher rate before they have to. This gets them used to extra repayments while reducing the mortgage through overpayments.
Make sure the loan is structured to get the most out of your hard work, says Meredith. On most fixed-rate mortgages, banks will allow you to repay an additional 5% per year without penalizing you, she says. If you want to repay more, you can keep the money in a savings account until you can restructure the mortgage.
One of the easiest ways to structure a mortgage for overpayments is to leave some principal at a floating (variable) rate, which doesn’t penalize overpayments. If there’s any chance you’ll need to make some of those overpayments again at a later date, then consider getting a mortgage with a drawdown facility, Meredith says. A revolving credit mortgage can also be the solution.
Not thinking about it in advance can lead to difficulties. Meredith was approached by a couple who had paid off more than a third of their mortgage in two years. When one member of the couple was unable to work, the bank decided that he should continue to pay at the same rate he was charging voluntarily, which he could no longer afford. It didn’t make sense because they could still afford to make standard repayments on the original term. But the bank did not move. Meredith managed to remortgage them with another bank that might make sense.
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