Paying off your mortgage as soon as possible is essential to building wealth. We know that while mortgage interest rates are at historic lows, they are likely to rise, and so the sooner you pay off your mortgage, the better your financial situation will be when they do.
Unless you are prepared to take on a high level of risk or borrow to invest, paying off your mortgage should take precedence over investment. The sooner your mortgage is gone the sooner you can create wealth for your retirement or other life goals such as travel. Saving money in a bank account at interest rates just above zero before tax doesn’t make a lot of sense when you are paying 3-5% interest on your mortgage. However, it is good to have cash on hand for when unexpected expenses crop up or to save for short term goals like holidays and Christmas presents.
Some banks now offer offset accounts to help solve this problem. With this system, the combined balances in your bank accounts can be subtracted from the amount owing on your floating interest mortgage when the mortgage interest is calculated, so you pay less interest. This can be a good way of saving for short term goals while keeping your interest payments down.
A different approach is needed if your aim is to pay off the principal of your mortgage more quickly. Ideally, as much of your spare cash as possible, over and above what you need for short term goals, should be used to reduce the amount you owe. However, there can be difficulties with that. If you have fixed the interest rate on your mortgage and you would like to either increase your regular repayments or pay off a lump sum, there is likely to be a limit as to how much you can repay early without a penalty. As well, there is a danger that if all your spare money is used to repay your mortgage, you may have insufficient funds on hand when unexpected expenses arise.
There is a simple solution to these problems which allows you to apply as much spare cash as possible to your mortgage without incurring penalties and without reducing your access to funds for emergency purposes. I call it ‘chunking’ your mortgage. Here is how it works.
The system is based on a line of credit, sometimes called revolving credit. A line of credit is a type of floating interest rate mortgage on which you are only required to pay the interest on the balance owing and on which you can draw down money if required up to an approved limit. For example, if you have a line of credit of $50,000 and repay $20,000, you can take back the $20,000 at any time without needing the approval of the bank. This means all your spare cash can be paid into the line of credit to keep interest payments down and drawn down if and when needed. Your mortgage can be divided into ‘chunks’, one of which is a line of credit. The other two chunks might be one chunk that is fixed for one year and one chunk that is fixed for two years.
You can put all your short term savings into your line of credit, in the knowledge that if you need it, you can take it back out again. When your one year fixed chunk comes off fixed, you can take money out of your line of credit to pay off a chunk before fixing it again for two years. The repeat the process. Over the next year, save into the line of credit and when the next part of your mortgage comes off fixed you can take money out of your line of credit, pay off a chunk and fix the remainder for two years. You can also use a mortgage offset account in the same way.
While this system sounds complicated it is really very simple. There are two very important rules to follow when using the chunking system. Firstly, never use the funds available in your line of credit to pay for everyday expenses. Funds should only be drawn to pay for the things you are saving up for or to pay off your mortgage. Secondly, set a clear target each year for how much of your savings you aim to use to pay off your mortgage and stick to it.
Using a line of credit requires discipline and is not for everyone. Deciding how to structure your mortgage is best done with the help of your bank or your mortgage broker.