Luke and Sophie are a couple in their 30s with two young children. They’ve been lucky enough to buy a house, but they’re still making payments on it, and on top of that, they have a personal loan and some credit card debt.
Their debts include:
Mortgage (30 year loan term)
- Loan balance: $400,000
- Interest rate: 2.59%
- Current repayments (per month): $1599
Personal loan (5 year term)
- Loan balance: $20,000
- Interest rate: 11.11%
- Current repayments (per month): $436
Credit card
- Loan balance: $10,000
- Interest rate: 20.00%
- Current repayments (per month): $1,000
Their total debt is $430,000 and their total payments per month add up to $3,035.
At this rate, it will take them about 30 years to pay off their mortgage.
Luke and Sophie want to pay off their mortgage sooner and they’d like to simplify their monthly payments, so they decide to look into some strategies for debt repayment, namely:
- Refinancing and debt consolidation
- Increased loan repayments and increased frequency of repayments
- Optimising a mortgage offset account
Refinancing and debt consolidation
Refinancing means changing the terms of a loan—either by taking out a new loan from your current lender or changing to a different lender. For example, if you had a mortgage with 4% interest but wanted a lower rate, you might refinance for a 3.5% interest rate. In addition to lowering your interest rate, you may be able to change your payment period and other loan terms.
Debt consolidation is the process of combining multiple debts into one. For example, if you have three credit cards, you could transfer all three balances onto one new card. Now you’ll only be making one monthly payment instead of three. Sometimes, you can save money by consolidating your debt. In the credit card example, you might put all three debts onto one new card that has a better interest rate.
Luke and Sophie decide to consolidate all their debts into their mortgage. They won’t be changing the terms or interest rate of the mortgage, but they will be bundling the $20,000 from the personal loan and the $10,000 from their credit card into the mortgage.
Now, they only have one loan and one monthly payment:
Mortgage (30 year loan term)
- Loan balance: $430,000
- Interest rate: 2.59%
- Current repayments (per month): $1,719
They still have the same amount of total debt ($430,000), but now instead of $3,035, their monthly repayment is $1,719, and their interest rate is much lower.
By consolidating the loans, Luke and Sophie now have a cash flow saving of $1,316 per month.
Increased loan repayments
Now, Luke and Sophie could simply enjoy that extra monthly cash flow, or they could put it to use.
Because they were paying $3,035 before, they know they can afford to do that again. So they decide to pay $3,035 per month toward their mortgage.
Before debt consolidation, it would have taken them about 30 years to pay off all their debt and they would have accrued $182,922 in interest.
Now, after consolidating their debts and increasing their payments to $3,035 per month, they can pay off everything in just 14 years and 2 months and they will have accrued only $83,789 in interest.
Altogether, that saves them $99,133 and they’ll pay off their debt 15 years and 10 months sooner.
Increased frequency of repayments
But wait, Sophie thinks, since interest accrues daily, couldn’t we save even more by making more frequent payments?
She and Luke decide to do an experiment: instead of paying $3,035 at the end of each month, they’ll pay $1,518 at the end of each fortnight. They’re not paying more per month; they’re just paying more often.
Remember that paying $3,035 per month would allow them to pay off their debt in 14 years and 2 months with $83,789 cumulative interest.
By paying $1,518 every fortnight, they can now pay it off in 12 years and 10 months with only $75,463 cumulative interest.
That saves them $8,326 in interest and allows them to pay off the loan 1 year and 4 months sooner.
Total savings
Luke and Sophie have now:
- Consolidated their debts into the loan with the lowest interest rate
- Increased their loan repayment amount
- And increased the frequency of their loan repayments
Let’s review just how much they saved by doing this.
Initial debt
- Cumulative interest: $182,922
- Loan term: 30 years
New strategized loan
- Cumulative interest: $75,463
- Loan term: 12 years, 10 months
Thanks to successful debt strategizing, they’ve shaved off $107,459 in cumulative interest and will be able to pay off their debt 17 years and 2 months sooner.
Optimising the mortgage offset account
If Luke and Sophie wanted to cut down that interest even further, they could use a mortgage offset account.
This means they would link their savings account with their mortgage and only be charged interest on the difference between their mortgage balance and their savings account balance. In exchange, their savings account would not earn any interest.
For example, if they have a principal balance of $430,000, with $20,000 in savings, they would only accrue interest on $410,000.
