So, what are you doing with all that interest you’re saving?
In case you haven’t noticed, interest rates are at an historic low right now. In August, the RBA voted to drop the official target cash rate to just 1.5%. This followed a reduction in May from 2.0% to 1.75%. Home loan rates are about 3 percentage points higher than this. If you have taken out a loan in the last 25 years, then you have never met interest rates lower than they are today. Open this window and have a look at the included graph to see what we mean:
These low rates represent great news for borrowers. And the news might get even better:
The average home loan in Australia is a tick over $350,000. If interest rates fall by 0.25%, this equates to a reduction in annual interest of $875. Given the two falls so far this year, the average home loan borrower is paying $1,750 less in interest than they were this time last year.
If you are a borrower, this is a good time to stop and think about how you are managing that extra interest you are saving. Are you saving your saving, or are you spending your saving?
Our advice is that you should almost always save it. Don’t let the extra amount find its way into consolidated revenue from where it is spent along with all your other dollars. Before the interest rates were reduced, you were probably coping with the amount you had available for spending. You will keep coping with this much. Don’t let your spending creep up. If you do increase your spending, what will you do when interest rates rise again? And they will rise again – that is what happens when things are at historic lows. When interest rates rise again, it will be very difficult to cut your spending back.
So, save your saving. There are various ways to do this, but a couple are particularly clever. Let’s look at those two.
The first is the simplest: simply maintain the previous level of monthly payments to your bank. Act as if interest rates have not changed at all. This is the easiest because you don’t have to change anything.
If you owed $350,000 in April and your loan still had 20 years to run, then your monthly payment to the bank was about $2,290. After the two interest rate drops, if you kept up the same level of monthly payments, then you shortened the time left on your loan to 18 years. That’s a 10% cut. Ignoring inflation, if you then kept saving the $2,290 for the next two years, you would save an additional $55,000. That is serious money.
Another alternative, which is a bit more fiddly, is to save the saving through your super fund. You can get a bit of a tax advantage here, because you can usually contribute into your super fund using pre-tax dollars, whereas money repaid on a home loan is paid after tax. So, if you pay tax at 37%, then the $1,750 in interest that you were previously paying required you to earn $2,770 before tax. You paid $1,020 in tax, and then paid the bank its interest.
Now that the bank does not want that $1,750, you can contribute the pre-tax $2,770 into your super fund without affecting your own personal spending. You avoid paying $1,020 tax yourself, and the super fund only pays $416 in tax. This means that you will end up with an extra $2,354 in your super fund. This is the same as investing the $1,750 and getting an immediate 35% return.
The alternative that you choose will depend on a range of circumstances, including your age. You can typically remove money from your super fund tax free once you turn 60. This means that saving into super makes more sense the closer you are to that age. You get to save larger amounts of money into super due to the tax benefits, and you can then withdraw a lump sum at or after age 60 and repay more of your debt than you could have making straight repayments.
If you are unsure what to do with the interest you are saving, why not give us a call? We will be all too happy to help you make the most of the interest you are saving, leaving you well-placed for when interest rates rise again.