In the current low interest rate environment, we’re seeing a lot of clients look at repaying debt quite aggressively (paying above the minimum or making ‘additional’ payments to their mortgage on a regular basis).
In reality, this is the best thing to do as far as debt reduction goes, and will set you up better in the long-term, by both increasing your equity position, and also decreasing the overall interest costs you pay for your mortgage over the life of the loan.
There can however be some downsides to this when applying for new lending, and I’d like to show you how to get around these so that you’re achieving your desired result, and also keeping the bank happy.
Loan affordability Criteria:
From a high-level perspective, banks are extremely conservative when it comes to calculating affordability. Basically what they do is calculate income coming in (different types of income are treated differently) and then calculate expenses/outgoings (for mortgages this is done with higher test rates than your actual mortgage outgoings, OR if making additional payments, the higher of the two) and then what remains is known as a Uncommitted Monthly Income (UMI). This figure supports proposed new borrowing.
This might mean that if you are reducing your debts aggressively and paying well above the minimum, what you might be able to borrow could be lower than if you were paying the minimum payments on your mortgage.
A lot of this has come about due to the “Responsible Lending Code” and has meant that there hasn’t been too much common sense in the process, because in many cases you; 1) are making higher payments on your debt because you can afford to, and 2) you can reduce the payments back to the minimum if necessary.
What do we suggest as a solution? We would recommend looking at splitting your mortgage so you can achieve the best of both worlds, which might look something like this:
Current scenario:
Let’s say you have $1,000,000 of debt, at 2.29% fixed for 12 months which has minimum payments of $3,843 p/m assuming a 30-year loan term. You’ve however decided to pay $7,500 per month to get your loan down faster. This means you’re paying down an additional $3,657 p/m principal over and above your existing principal and interest payments.
An alternative scenario might look like this:
Fix $950,000 for 12 months at 2.29% (minimum payments of $3,651 p/m).
Set-up a revolving credit of $50,000 at circa 4.5% (rate might be lower if you get a discount) and pay the difference of $3,849 per month into this facility. The interest-only costs would be (straight-line) $187.50 per month, and you’d be paying off $3,661.50 per month of principal.
This achieves the benefit of still reducing your loan by a large amount on a regular basis and also satisfies the banks because you can stop making your monthly additional payment at any time, and the banks view the revolving credits differently.
If you think you need to review your own situation to put yourself in a better position for future lending, feel free to get in touch at info@krispedersen.co.nz