The “magic” of fortnightly repayments

IF you’re keen to pay your home loan off sooner, you are most certainly not alone as this is a commonly voiced objective for many borrowers and is a worthwhile aim that will save you a great deal of interest expense in the long run.

You may have heard that paying your home loan in fortnightly installments rather than monthly is an easy way to shorten the term of your loan and save you thousands in the process.

Some pundits who should know better claim that the savings are a result of the “magic” of compounding interest working in your favour. Sadly, as with all forms of magic, this is simply an illusion.

The more honest explanation is that while there is a small effect due to compounding, the main benefit is derived from making additional payments.

The assumption is that you will pay half of the monthly figure each fortnight, but as there are 26 fortnights, you are effectively paying an extra month each year.

That’s not a bad thing, it will pay handsomely in the long run, but it is your thrift and discipline producing the results, not the “magic” of fortnightly repayments.

The financial services regulator ASIC provides some useful tools and calculators at moneysmart.gov.au and you can use these to explore your own numbers.

Consider a $250,000 loan at 4.15 per cent for 30-years. The difference between paying monthly and paying half the monthly figure each fortnight is an interest saving of around $30,000 over the life of the loan (shortened by over four years) – this is an impressive figure.

We can also check the difference between monthly payments and the genuine fortnightly payments, a rather underwhelming $205 and no impact on the term of the loan.

A quote ascribed to Thomas Edison is that “genius is one per cent inspiration and 99 per cent perspiration”. In this example we can see that less than one per cent of the savings are due to the compounding effect and more than 99 per cent is down to your diligence.

When it comes to paying down any debt, it’s hard to avoid the “no free lunch” rule. The main exception is the effect of refinancing to a lower rate.

In the example above, if the interest rate is lowered to 3.9 per cent and monthly repayments are left unchanged, the total interest saving comes to around $23,800, with no extra “perspiration” required.

For more information please contact frank.tamayo@iconnectfinancial.com.au.