Q: I currently have a principle and interest loan paid fortnightly. Would I be better off using an offset account for my savings and changing to interest only? Which strategy will equate to a more rapid mortgage reduction?
A: The most appropriate loan structure and repayment method will depend on the interest costs of your loan, your income, your cash flow needs and how disciplined you can be around money and debt reduction.
Principle and interest loans work best for those who want the certainty of knowing the loan will be paid off on or before a pre-determined date. Borrowers are often motivated by seeing the loan balance diminish on a monthly basis. They may also need the forced discipline of regular principle payments. Principle and interest loans are typically offered by lending institutions for between 1 and 30 years. Obviously, the difference in loan term duration will determine the size of the contracted monthly payment and the ultimate amount of interest you pay.
Interest only loans work best for those who want the lowest minimum monthly repayment on a mortgage or do not wish to focus on paying the debt down immediately. Borrowers may require greater flexibility as to how and when they reduce the debt or may wish to maintain a level of debt for tax planning purposes. Whilst the loan term may be up to 30 years, typically a loan will revert to principle and interest after five years interest only.
Fortnightly loan repayments are an effective means of paying back a debt quicker. There is no great mystery to why; a fortnightly loan repayment is set at half the monthly loan payment obligation, however, there are 26 fortnights in a year so you make an extra monthly loan repayment a year.
An Offset account offsets the balance of the account against the outstanding loan balance. Mortgage interest is typically calculated on a daily balance so the more you have in the offset account and the longer you retain the balance in the account, the greater the interest offset.
Whether you pay more off the actual loan or leave more in an offset account, they have the same effect on the interest charged.
In deciding whether to have a principle and interest or interest only loan, consider your long term debt needs, the difference in interest costs and your cash flow requirements. Can you afford higher minimum payments associated with a principle and interest loan or do you require the comfort of a lower minimum payment in the event of a change in circumstance?