What’s going on guys Its Jordan de Jong here and today I want to talk about some terms we frequently hear when securing a loan for a property, these include principal and interest, interest-only, fixed, variable and an offset account. Obviously, there’s a whole bunch of other financial jargon that goes into a loan contract, but these are the 5 main terms I commonly get asked about and although they may seem pretty straight forward on the surface, most don’t actually know what goes on under the hood. Firstly, let’s tackle principle and interest, also known as P&I when you take out a loan to borrow money from a lender to pay for a house, you “Theoretically” have to pay that money back, and it comes at the cost, also known as “Interest”. So you can put of the money you’re paying back, to pay off that loan, into two different categories, one is principal which is the total amount that you borrowed and two is an interest which is the money it costs to take out that loan. If you’re on a principal & interest loan, this basically means you are paying both of these off simultaneously, a proportion of your repayments goes towards paying down your loan and the remaining is charged as interest from your lender and you’ll never see it again. Now that P&I is out of the way, Interest only or IO for short is pretty self-explanatory, if you are on an Interest Only loan, essentially you are only making those interest portion repayments, and not paying anything down on your loan. Obviously, the more of your loan you pay down the less interest you have to pay every repayment, so it makes sense to go on P&I right? Well, I think this is where most people’s education level stops and it’s just presumed that P&I is the best way to go long term. We’ll delve into why this way of thinking may even be harming your financial position long term at the end of this vlog, for now, let’s cover fixed vs variable but before we do that don’t forget to smash that like button. Fundamentally there is this thing called the cash rate, this cash rate impacts the interest rates that lenders charge you to take out a loan, when the cash rates changes, so do interest rates. A variable loan is directly impacted by this, because.. its variable, it changes with the interest rate changes your lender makes, a locked-in fixed loan doesn’t get impacted, because you have locked in a fixed period, generally 1-5 years, where the interest rate doesn’t change. So essentially you're making a bet against the lender, if you think the interest rate is going to go down, generally you would keep the loan variable so you can take advantage of these interest rate drops, and vise versa if you think interest rates are going up, you would want to lock in that lower rate. Again, this seems pretty straight forward on the surface, but under the bonnet, there are other things going on, such as currently fixed loan interest rates are lower than the variable interest rates, and if you went variable over fixed, it would take multiple interest rate drops to see the same or a lower rate on an equivalent fixed loan. In addition, fixed loans in most cases have limited other features, such as an offset account, and herein lies, the greatest gift that lenders have given all Australians, an offset account is a separate account that is linked to your loan, however, the funds that are in that account reduce the calculated loan amount. So if you had a $500,000 loan, and $100,000 in an offset account, you would only be paying interest on $400,000, so although you’re not technically paying off your loan in the same way you would on a principal & Interest loan, your still reducing your repayments in the same way. The added benefit with an offset account is you can still use the money in that account freely if a major event came up and you needed the money handy you could just take it out of the offset account without any complications, where once you’ve “paid” down the loan, in a P&I scenario, it’s not as accessible without implications. To clarify my earlier statement that P&I loan may even be harmful for your financial situation, I want to introduce you to the amortization schedule, for this example we are demonstrating a $500,000 loan over a 30 year period on a 4% interest rate. As you can see our total interest paid is pretty significant in comparison to the actual loan amount, our calculated monthly repayment is $2,387, but let’s see how this is broken up under the hood, as you can see, the interest portion of this monthly repayment is much higher than the principal repayment. In the first month, we are paying $1,667 in interest compared to only $720 in principal, and it stays at this proportion for quite some time until slowly this amount shifts over that 30-year loan period until there is much more principal being paid than interest. So, in the case where you had an offset account, and you put that same $2,387 monthly repayment into the offset, the repayment portions would work the same. However, say you could put $3,000 into your offset every month, then all of that additional $613 would go straight towards reducing your loan, and have a much more dramatic impact on your next interest repayment. And if you didn’t know, interest actually gets calculated daily, so say you got paid every week or fortnight and it went straight into the offset account, well you would be reducing your interest by that full amount in the offset from the first night after it lands into your account. Which in theory reduces your interest, meaning your saving more money, and the more money you save in that offset account the less interest you pay again and again and again, so its essentially a snowball effect to pay down your loan. Now I’m not a financial advisor or mortgage broker so please seek out your own professional financial, legal, taxation & property investment advice for your current situation, these blogs are just my opinion and general in nature and should never be considered personal advice. But for me personally, on my principal place of residence my typical loan structure is an Interest only, variable loan with an offset account attached that I park all my savings into, which reduces my total calculated loan amount. One last hidden gem, because I’m confident in my ability to control my spending, I use a 55-day credit card for all non-discretionary expenses, this allows me to pay for bills upfront without the money actually coming out of my account for another “55 days”. leaving more in my savings to reduce the calculated loan interest, and even better yet, my credit card automatically gets paid out, on time from my offset account, I want to know if you guys have any other hidden gems for your mortgage strategy, leave it down in the comment section below. Until next time, happy house hunting.

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