How to build wealth with debt - Strategies that work!
This is your ultimate guide to paying off your mortgage ahead of time.
Whether you have recently had a home loan approved or are already several years into the term of your mortgage, you may be thinking about ways you can pay it off early. However, the reality for most homeowners is that they will carry their mortgage for at least 25 years.
The ability to grow your wealth and pay off your home loan ahead of time requires well-executed finance strategies. We will explore some smart ways you can save money – and years – off your mortgage while also building a portfolio of income producing assets for a comfortable retirement. Your future generations will also thank you for your smart decisions.
To illustrate how this can work, we will use a scenario that we often find with new clients. Even if this example doesn't resemble your situation, we encourage you to reach out to one of our brokers to develop a strategy for you. Remember, the earlier you start, the greater the wealth potential.
Meet Phil and Claire. They are couple in their late thirties and have two children. They both work full time and earn a combined net annual income of $120,000. After expenses are paid each month, they have a surplus of $1,500 and they have saved $25,000 which they spread across multiple bank accounts.
Phil and Claire’s home is valued at $1,000,000 and the balance of their mortgage is $700,000. They initially took out a low two-year fixed rate home loan which has now expired and reverted to the bank’s standard variable rate. Their monthly repayments are $3,000.
There are some things Phil and Claire can do immediately to start saving. We will start with the basic changes and build up to strategies that Phil and Claire can implement to speed up the process of becoming financially free.
Switch to fortnightly repayments
Phil and Claire are currently making monthly repayments on their home loan. By paying half the monthly amount every two weeks, they will make the equivalent of an extra month’s repayments each year.
Find a lower interest rate
After their fixed rate expired, Phil and Claire’s mortgage reverted to the bank’s basic standard variable rate product which is not competitive with the rest of the market. Phil and Claire can either try to negotiate for a lower rate with their existing bank or they can refinance to a new lender and take advantage of record low interest rates.
Use an offset account
An offset account linked to your home loan works the same way as a regular bank account. However, the balance in this account is “offset” against the balance of your home loan to reduce the amount of interest you pay to the bank.
There is the ability to have a completely variable home loan or a split home loan with a portion of the mortgage fixed. Both options allow a 100% offset account linked to the variable component.
Phil and Claire have $25,000 spread across three different bank accounts, each earning interest which they need to declare as taxable income. By moving their savings to an offset account and contributing the existing $1,500 surplus cash each month, they will save thousands of dollars and cut years off the term of their mortgage. Let’s see how this works.
Loan Amount:
$700,000
Starting Offset Balance:
$25,000
Ongoing Offset Deposit:
$1,500 per month
Interest Saved:
$136,019
Time Saved:
13 years, 11 months
You can see that the balance of Phil and Claire’s home loan after just five years of using an offset account is now almost $100,000 less than what it would be if they choose not to include an offset account with the mortgage.
It is important to note that calculations are indicative only, outcomes assume that interest rates will not change, and all payments are made on time. These calculations are based on the current low interest rates. If rates increase over time, the potential savings with an offset account are even greater. You can read more about offset accounts right here.
Accelerate Your Wealth
Growing wealth requires planning, leverage, and time. With the right finance strategy and asset selection with compounding growth, you can accelerate your wealth creation.
Investing is not for everyone. There is an element of risk involved and without educated and well-executed decisions, investing can be detrimental to an individual. If you are not comfortable investing on your own, a professional advisor can help develop a strategy for you.
Now, let's see how investing can help Phil and Claire achieve financial freedom early.
What is leverage?
Put simply, leverage is the controlled use of borrowed money to purchase part or all of an asset in the hope that it will make a profit that is more than the interest payable on the amount borrowed.
Let's look at two investment options to illustrate leverage.
Say you pay a 20% deposit for a $500,000 investment property. Your initial investment is $100,000 (excluding all costs). Over 12 months, that property appreciates in value at 5% giving you an asset value of $525,000.
Alternatively, you use the same $100,000 to purchase $100,000 worth of shares that appreciates at 5%. After 12 months, the asset value has increased by only $5,000.
The difference of $20,000 in asset values over 12 months represents the use of leverage. Naturally, the longer you measure these returns, the impact of leverage is even greater. Therefore, the key to investing and leverage is selecting the right asset.
What is equity?
Equity is the difference between the value of your home and the principal amount left owing on your mortgage. In the case of Phil and Claire, the market value of their home is currently $1,000,000 and the principal owing on their mortgage is $700,000. This means, Phil and Claire have $300,000 in equity.
Using the equity in your home is a great way to build a property portfolio. This is a strategy recommended for Phil and Claire as they don’t have enough cash available to purchase an investment property.
When we help clients use the equity in their home to purchase an investment property, we look at how much “useable equity” is available.
Banks aim to reduce their risk by allowing you to borrow up to 80% of the home’s value, without attracting Lenders Mortgage Insurance (LMI). Phil and Claire may have $300,000 in equity, but if they want to avoid being charged LMI, the amount of useable equity is only $100,000.
How did we work that out? Well, 80% of the home’s value is $800,000. Minus the amount owing on the mortgage and they are left with $100,000.
To begin investing, we would help Phil and Claire with a strategy which involves debt recycling.
Debt Recycling
What is debt recycling?
It is a strategy that turns your current home equity into a tax-deductible investment loan.
Phil and Claire bought their home a while ago and have slowly been paying off the mortgage and created $100,000 of useable equity. With debt recycling, they could borrow against this equity to buy an investment property that will appreciate in value and bring in a source of income.
4 steps to building wealth with "good" debt!
Have your home valued and calculate the useable equity
A good place to start is with an estimated online valuation, such as Property Value by CoreLogic or onthehouse.com.au. When you're ready to proceed, your broker will obtain a valuation for the bank to use. Calculate 80% of the estimated value and subtract your current home loan balance. For example:
Estimated value: $1,000,000
80% LVR: $800,000
Current loan: $700,000
Useable equity: $100,000
$1,000,000
$800,000
$700,000
$100,000
Take out an investment loan
You would now take out an investment loan which is secured against the available equity in your home.
Invest in an asset that provides income and capital growth
Your new investment loan would be used to purchase an asset that produces an income and also provides capital growth such as an investment property, managed fund or shares.
Pay down your loan
You can use the income generated from your investment, plus any tax advantages of a geared investment to pay down your non-deductible debt in your home loan.
Disclaimer: This is a simplified summary of a complex investment strategy and is intended to provide general information only. It does not It does not constitute financial advice and does not take into consideration your personal situation. We recommend you seek professional advice before acting.
With this strategy, you will build wealth as your investment portfolio increases in value over time. The cash flow you receive from your investments can be used to pay down your home loan ahead of time. By the time you reach retirement, your home loan could be paid off and your investments will provide a passive income to fund a very comfortable lifestyle. You will also be able to leave a special legacy for your next generation.
For this strategy to work, you will need...
A regular income that you can rely on to cover the interest payments on your investment loan.
A buy and hold approach to investing.
A willingness to increase your level of debt.
A tolerance for risk and fluctuations in the value of your investment.
The right insurances to cover you and your investment.
A cash flow buffer to cover any unexpected incidents with the investment, such as repairs to a property.
If debt recycling doesn't sound like the right strategy for you, we invite you to contact one of our brokers to discuss some other ways you can save on your home loan. You can also read more about paying off your home loan early, right here!
Now is the time to take advantage of this strategy.
Whether you're a beginner or experienced investor, find out how we can help you achieve financial freedom.
This article is intended to provide general information of an educational nature only. It does not have regard to the financial situation or needs of any reader and must not be relied upon as financial product advice. The information has been prepared without considering your objectives, financial situation or needs. You should consider the appropriateness of the information and seek professional advice before acting.