Say What Wednesday
Paying your home loan off with debt
How can you pay off a mortgage with debt? Velocity banking and Offset accounts
This question comes from Tom a podcast listener. He asks “Just wondering if you have ever used Velocity banking at all to pay down debt quicker?”
In this article, we will explore what velocity banking is as well as some alternatives to paying off debt with other debt available in Australia.
So what is it? And why haven’t we heard about it?
It’s a Strategy of Using a Line of Credit (LOC) to pay down principal on a loan. Typically used in the US.
How does velocity banking or ‘chunking’ work?
The LOC becomes your income and expenses account. You put your pay into it and pay all your expenses from it, including your mortgage repayments.
You use the LOC to pay down your loan through “chunking”. What this means is if your income is greater than your expenses, the LOC should build up by the difference every month. If your household income is $8k p.m. and your expenses (inc mortgage) are $6k, the LOC should build back up by $2k p.m. Once the LOC builds up to the maximum amount, use the total chunk to pay down the home loan again. Keep repeating this process until the home loan is completely paid off.
You spend more of your time repaying interest on a home loan during the life of the loan, than you do paying the principal.
Paying down a loan with more debt can be beneficial but it depends on if there is anything that works better available for you. You wouldn’t want to take action for faster repayments unless it was the best option for you to take. Everyone’s situation is different to it is important to consider alternatives, especially in Australia where we have other ways.
Does it work?
It depends on the strategy and the loan requirements. An individual can save a ton on interest repayments, but they can do so in other ways too. An example of an alternative strategy that is similar to velocity banking but possesses more advantages is using an offset account.
What is an offset account?
These are accounts that work similar to the LOC account, but you raise the funds through equity not borrowing. This is more common in Australia.
What does that mean and how does this work?
You skip borrowing the funds for the first chunk and just use the offset account as your income account. Use a credit card to pay expenses and then pay off the credit card each month from the offset account. The difference between income and expenses will reduce the total interest repayments on the loan as the sum in your offset account gets larger. Keeping as much money in the offset account as possible helps reduce the interest repayments on the home loan, as interest is calculated daily. Hence we pay off the CC at the end of the month, optimizing the time our savings spent in the offset account.
Let’s do a comparison between traditional mortgage repayments, velocity banking and using an offset account.
The situation is as follows: a couple have a $480,000 loan at 6% for 30 years. The repayments will be made monthly.
The individuals with the home loan have the following financial situation:
The normal interest repayments come to $2,878 monthly
- Normal interest repayments would mean paying the monthly repayment for the life of the loan ($2,878 pm)
- Chunking or velocity banking would be taking a LOC and treating it as a transaction account. Putting income in and taking expenses out. In this example, the LOC will be $20,000. The LOC will be paid back in 10 months to $20,000 at which point in time the chunk will be used to pay down the home loan.
- Using an offset account will be treating the offset account as a transaction account. Putting your income in and taking expenses out. Building up the offset account over time until the loan is paid off.
Which one is better?
Normal repayments appear to be the worst, you are paying $555,477 in interest over the entire life of the loan. In addition, the loan lasts a full 30 years, 19 years more than using an offset account with the case study.
With an LOC and chunking your payments, you pay $191,227 in interest on the mortgage. Plus an additional $10,339 for LOC at 8% p.a. A total of $201,566, saving the individuals $355,000 on their home loan.
With an offset account, however, you pay $175,928 in interest which is a reduction of $379,540 in interest over the life of the loan. The table demonstrates that an offset account is best. You pay the loan off in the least amount of time and as a result, you pay less in interest overall.
So what are the advantages?
You can pay off the home loan faster by making additional payments sooner. This significantly improves the time it takes to completely pay off a mortgage.
Pay less in total interest repayments over the life of the loan. These savings allow you to do more with your money after the home loan is paid off.
What are the disadvantages?
It requires free cash flow, as you need to have more income than expenses. All the strategies for paying off your home loan faster require the ability to build up funds against the loans. The LOC has a higher interest rate, so this will be a more expensive strategy.
An LOC requires equity in the property to be used effectively. An offset account is ready to use with savings so you can start from scratch. The LOC strategy requires capital growth on the house or waiting for the principal to be repaid a bit.
That money that you are saving each month could be deployed to purchase other properties or investments that grow, rather than helping to pay off any specific loan.
In summary, it’s worthwhile looking into an accelerated home loan repayment strategy. The faster you pay it off the more money you save in the long run. Regular principal and interest repayments plus an offset account are useful to consider to help pay off a home loan sooner.
This question has got us thinking about another strategy as well to try and remove the opportunity cost involved with personal debt. By breaking it down into a debt recycling strategy and learning how to leverage this, can help build wealth over time.
Feel free to get in contact with us at https://financeandfury.com.au/contact/