The Loan That Never Dies
Don't create a loan that never dies
One of the biggest misconceptions in refinancing is that borrowers can save money by extending a current loan. Extending a loan is just another way of making sure it never dies. If a borrower is into the 5th year of a 30 year loan and pays $1,803/month ($250k loan), he or she could be tempted to reduce monthly payments to $1,711/month with the exact same interest rate of 7.82%. How is that possible?
The explanation lies in simple maths, as Table 1, below, indicates. After 5 years, the debt has been reduced by $12,723 to $237,277. By refinancing to another 30-year term, this borrower simply stretched his or her current loan in order to lower the monthly repayment. The end result might look good in the short term, but there is less contribution to principle payments. This is simply a loan life support strategy. At RateCity you can search and compare over 2,000 mortgages and use RateCity's loan repayment calculators to give you an idea of how far your budget will stretch to.
Affordability is a critical concern for many Australian households with large mortgages. For some consumers entering the mortgage market for the first time, an extended term might make sense for this reason. However, if the objective of home ownership is to build equity and wealth, then extending the loan term will often do just the opposite: it will build debt.
In the case of our example below, the borrower will end up paying an extra $75,152 over the life of the loan in exchange for a reduced monthly payment of $92.
| Table 1. Cost of extending your loan term | ||
|---|---|---|
| Initial Loan Balance | Monthly Repayment | |
| Loan 1 | $250,000 | $1,803.14 |
| Loan 2 | $237,277 | $1,711.37 |
| Total you pay for Loan 1 | $649,129.97 | |
| Total you pay for combination of Loan 1-2 | ||
| Loan 1 (year 1-5) | $108,188.33 | |
| Loan 2 (year 6-35) | $616,094.12 | |
| Total | $724,282.44 | |
| Difference | -$75,152.47 | |
There are some cases where extending the loan term makes sense, especially for investment purposes. Tax concerns are an important factor in this equation. Investment loans are eligible for tax deductions but residential loans are not. Investors hoping to minimize tax may in fact come out ahead by extending the term of investment loans.
Forty-year loans have now appeared on the Australian mortgage landscape, with eight institutions marketing these. As with all loans, they are excellent if used correctly. In most cases though, the temptation to extend the term of any loan just to decrease the monthly repayment size can be a backwards step.
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