A Love Affair with Debt

Mortgage rates peaked at 20.50 per cent per annum in June 1987.   Since 1990 interest rates have been in a steady downtrend, with the last five years in particular, seeing rates in a band of 6.00% to just under 9.00%. Even within this range, folk are subject to significant cashflow pressure if they have not selected the correct debt facility, or are over-borrowed, and interest rates rise.

Household debt is at all time highs with a debt ratio of 140% of annual household disposable income as apposed to only 60% 15 years ago. Our love affair with debt continues.

While all this may be fine, and there are more than 1.1 million mortgage holders and $120.5 million borrowed, it seems that many do not even understand what types of mortgage are available and what option is best for their need. There are three key styles of mortgage; table, revolving credit and straight-line, plus fixed or floating rate options to consider.

The most common type of home loan is a table mortgage. You can choose a term, 15 years or less and up to 30 years with most providers. Much of your initial repayments fund the interest, while the later payments go to pay off the principal (the amount borrowed). Table loans can be fixed rate of interest or floating rate or a blend of both.

Among the benefits of table loans are the discipline of regular payments and a set date when they will be paid off and the certainty of knowing what payments will be (with a floating rate repayment amounts can change, or the term will be extended).

Revolving credit facilities work like a large overdraft. All of your income goes straight into the same account. Bills are paid when they are due. By keeping the loan balance as low as you can, you pay less interest because of daily interest calculations.

Lump sum repayments and re-draws are fine. Some gradually reduce the credit limit available to encourage you pay off the mortgage.

These schemes suit people with irregular income as there is no fixed repayment. By holding surplus funds, rather than in a separate savings account, will give interest savings and also avoid tax on the savings account interest.

On the negative, folk need discipline. It’s tempting to spend to your limit and stay in debt longer. Also, the statements record the total debt load and this can be stressful for some folk.

The third style is straight line. You repay the same amount of principal each repayment, but a reducing interest each time. While relatively rare in New Zealand payments start high and reduce (straight line) over time. You pay less interest overall than with a table loan because early payments include a higher repayment of principal.

However if you can afford higher payments, you could be better to take a table loan with payments high for the whole term (shorter), thus paying less interest.

Interest only plans are when you don’t repay what you’ve borrowed until an agreed time. Some take an interest-only loan for a year or three and then switch to a table loan later. You then have more cash for other purposes, such as renovations or extensions. These plans are useful when borrowing for investment purposes also.

With fixed or floating rates many folk have their own opinion. Generally speaking we do not see long term fixed rates in New Zealand. In US you can select up to 30 years fixed. Most NZer’s only go for one or two years maybe three, fixed and even then they have no idea why they selected the term. Check out the cash rate/fixed interest yield curve, with a positive curve it’s time to fix at below the long term curve rate if possible. With an inverse curve stay floating or fix short only.

But above all remember, debt can be good if you control it. Don't let debt get out of control as it must be repaid at some point by you - dollar by dollar – plus interest.

Original Article published February 2006