In Your Interest: A Mortgage Buffer
The Reserve Bank's decision this week to once again leave the official cash rate at a record low of 1.5 per cent is likely to encourage prudent homebuyers to keep building up or at least maintain their mortgage buffers if possible.
Homebuyers who make higher repayments than the minimum required are developing a valuable buffer to help cope with future rate rises or unexpected financial setbacks. A mortgage buffer makes much sense.
More than three years ago, the Reserve Bank reported that "anecdotal evidence suggests" that about half of households had not reduced their regular monthly repayments as interest rates had fallen. And it is likely that this buffer-building pattern has continued through the subsequent years of rate cutting.
The central bank's latest half-yearly Financial Stability Review, published in October, records that mortgage buffers held in lenders' offset accounts and redraw facilities remain high at about 17 per cent of outstanding loan balances. This equates to about two and a half years of scheduled repayments at current interest rates.
"However," the bank cautions, "these aggregate figures mask significant differences across individual borrowers. Many borrowers have little or no buffer, especially the newest borrowers and those considered more at risk of experiencing financial stress, such as borrowers with lower wealth and income or higher leverage."
A loan with a redraw facility enables borrowers making extra repayments to withdraw the money if needed. And a mortgage offset account is a saving or transaction account attached to your mortgage with the current credit balance offset against your mortgage, reducing interest payments.
Some financial planners liken the making of additional mortgage repayments to making a higher-yield, tax-free investment that involves no risk.
Take the example of a homebuyer with a 39 per cent marginal tax rate (including Medicare) and home loan with a 4.5 per cent variable rate.
For such a homebuyer, the making of extra repayments is the equivalent of earning a pre-tax return of 7.38 per cent on a fully-taxable investment. There is no risk involved because the repayments had to be made anyway.
The mortgage calculator on ASIC's consumer website MoneySmart shows how much a homebuyer might save in interest by making even relatively modest additional repayments every month. Take a homebuyer with a $300,000 capital-and-interest loan with a current variable rate of 4.5 per cent. The loan term is 30 years.
Based on certain assumptions, MoneySmart calculates that by repaying $100 extra a month, this homebuyer will cut the term of loan from 30 years to 26 years and five months while saving more than $34,000 in interest.
One of the calculator's assumptions is that the interest rate will remain at the extremely low rate through the life of the loan, which, of course, is highly unlikely in the real world. In practical terms, this means that making higher monthly repayments than required while rates are so low is likely to produce significantly larger savings that suggested by the calculator.
Keep in mind that the Reserve Bank has cut the official cash rate 12 times since the beginning of November 2011 when the official rate was a much higher 4.75 per cent (against 1.5 per cent today). This opportunity to build-up a solid mortgage buffer is hard to ignore – if you can afford it.
Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment.