Your mortgage interest payment is your biggest cost as an investor. The good news is that there are ways to reduce this cost.
Your Investment Property magazine asked mortgage expert Michael Lee to explain...
As an investor, your goal is to maximise income and minimise expenses, right? Take a quick skim over your profit and loss statements for the last few years and you’ll probably find that your finance costs are among your biggest expenses, if not the biggest expense you have.
You’ll also find that your accountant calculates this expense using a standard method, with all related costs included, then publishes your finance cost as $X, rather than “Y% plus ascertainable fees and charges”.
That’s exactly why last month I suggested using a standardised Total Individual Cost (TIC) to calculate, compare, value or negotiate your mortgage deal. After all, if you can’t pin a price on it, how do you know if you are getting a good deal, a great deal or a shoddy one?
This triggered a torrent of questions, like why is TIC better than rate; why shouldn’t I trust what I’m told; and, my absolute personal favourite, how can I do it myself to make sure I’ve got the facts?
This article covers all that and more. So, providing I don’t send you off to the land of snooze, in a few minutes or so you’ll have all the knowledge you need to shop your deal like a pro. And, trust me, if you didn’t do it right last time (which most people didn’t), you’ll scoop up a few grand in savings and maybe get some nifty features added too. Let’s get started…
TIP 1 Banks, building societies, credit unions and mortgage brokers are awesome, but…
…their job is to help you get into debt. Providing you are borrowing responsibly and they treat you honestly and fairly, then what they do is cool, because without them your ability to invest might be severely limited. However, with so many of them keen to throw money in your direction, while proudly shouting that they have the best deals/rates/ features, it’s time to fix your mindset.
The power to get a better deal if you want it starts with a small step: instead of talking and thinking about these businesses as banks, building societies, credit unions and mortgage brokers, let’s agree to call them bidders.
It might seem like an odd term at first, but they are all fighting to win your business, right? So ‘bidders’, with no disrespect, fits.
TIP 2 Don’t cross your wires
Trouble starts for most borrowers when they mix the idea of a bidder trying to sell them a product with the belief that the bidder is a qualified, independent adviser. Sure, anyone who provides credit assistance should be licensed, and with that comes insurance and training. However, taking advice from the product seller is fraught with obvious danger, because most of that training is about how to sell their products.
Now we won’t dwell on that too much, except to remind you that bidders want you to buy a loan from the range they sell, rather than one they don’t. Obvious, right?
What’s not so obvious is that the bigger the loan, the more money they make, and a 5% increase in your borrowings can for some bidders increase their earnings by a much larger proportion. But that’s not where conflicted remuneration ends.
Bidders can also tweak their income when you take advice on fixed versus variable rates, or whether to pay interest only; on what loan type is right for you, or whether you should package a credit card, choose a different lender, or choose a different product within that lender’s product range.
So the answer is clear. Learn how to be independent, or hire someone who is. This article is dedicated to helping you learn how to be independent, and how to leverage the power of the TIC-it or flick-it approach.
TIP 3 Current methods
Why is TIC is the winning approach? To answer this, we need to look at some important concepts, starting with:
GIGO – An important universal constant
GIGO (pronounced guy-go) is an old computer programmer’s term invented so long ago that acronyms had four letters. Nowadays, of course, they usually only come with three. GIGO stands for ‘Garbage In, Garbage Out’.
So what on earth does GIGO have to do with you and your mortgage? It’s simple. Computers run on maths. The true impact your mortgage has on your life is also based on maths, even though the results are far more personal and the symptoms far more emotional. Every number and every rate out there claiming to simplify your decision, including TIC, relies on maths. This includes Advertised Comparison Rates, Personalised Comparison Rates, True Rates, Effective Rates, AAPRs, Overall Cost, and any others you encounter.
The important questions you should ask yourself are:
- What method has been used?
- Are all the variables relevant to you included?
- How accurate and consistent are the formulas?
It’s quite fair to say that most formulas reflect the general way lenders charge you various fees and costs, eg typical loan amortisation calculations. However, where GIGO becomes important is in the quality of the ‘variables’ entered into each formula, which produces each result. Garbage In, Garbage Out.
Wikipedia explains GIGO:
“...computers will unquestioningly
process the most nonsensical
of input data and produce
nonsensical output. It was
most popular in the early days
of computing, but applies
even more today, when
powerful computers can spew
out mountains of erroneous
information in a short time”.
In the same way that making small, regular extra payments slashes the time and money it takes to pay off your loan, changing the loan amount just slightly, excluding a fee or two or tweaking the term, can snowball into a massive difference in how much it costs you. What looks cheap might be quite expensive, and vice versa.
So the next time you are looking at a nice simple number, rate or rating designed to help you make a decision, remember GIGO.
The six o’clock swill
An even longer acronym from the
ancient annals of computing. It
stands for 'What You See Is What
It has absolutely nothing to do
with the world of mortgages.
At some stage towards the end of the 1990s, consumer advocates and various governments became increasingly concerned at the apparent trickery in use by some lenders and mortgage brokers advertising their credit products. This of course included mortgages.
Although the concern was probably across all products, there was a popular, justifiable view that both the banks and the brokers were emphasising low introductory rates to get borrowers through the door. These rates were relatively short-lived, with much higher step-up rates hitting the borrower for more than 90% of the loan term. Loans across the board also carried a raft of fees and charges that were not being divulged clearly to the borrower at the point of advertising.
Enter the Mandatory Comparison Rate. Although it’s not the legal term, I’ll call this rate the Advertised Comparison Rate as it’s the rate that must appear in all advertising.
The intention behind Advertised Comparison Rates, which were introduced in 2002, was to simplify cost comparison of different loan products for the ordinary borrower, ie those of us without degrees in accounting and finance.
In other words, the government created comparison rates to combat lenders that deliberately mixed in different rates and fees to make their loans difficult to compare with their competitors’. (Sound familiar?)
The industry term is ‘obfuscation’, which is to obscure, confuse, bewilder or stupefy – words often used by borrowers attempting to compare loans. Let’s just call it gobbledygook. Most, if not all, bidders like gobbledygook because it makes it easier to sell their loans. This probably explains why they caused the problem in the first place.
When the lawmakers mandated a standard formula allowing lenders to exclude fees that were ‘unascertainable’, what followed was kind of obvious. (So let me get this right: I can get any glass refilled just once?)
The cunning made as much of the loan cost unascertainable as they could. Perhaps worse, the legislation helped them justify the fact that they didn’t need to tell you about that cost until it was all too late. They began legally hiding fees that were once out in the open.
How? Well, there are a few different tricks but the simplest one is to take something like a settlement fee that would once have been a fixed amount, make it variable and call it a disbursement.
Because the amount of this ‘disbursement’ might change based on individual circumstances, it doesn’t have to be included in the Advertised Comparison Rate. The same is true for valuation fees and so on. Do this here and there and you can shave thousands of dollars off the apparent cost of a loan,
while doing nothing to alter the actual
cost of the loan.
“A comparison rate is a tool
to help consumers identify the
true cost of a loan. It is a rate
which includes both the interest
rate and fees and charges
relating to a loan, reduced to
a single percentage figure. For
example, a bank’s advertised
interest rate may be 5.49% and
its comparison rate 6.75%.”
Clever lenders developed fee and loan structures that meant comparison rates were rendered useless via each and every loophole they could find. By exploiting these loopholes, a surprising number of lenders have effectively manipulated the Advertised Comparison Rate to make their loans appear cheaper than they really are.
This, however, is just one crucial flaw. Others include:
- Advertised Comparison Rates do not consider massive fees, which vary in the thousands from lender to lender.
- Variations in loan amounts and/or loan terms can produce radically different real costs that contradict comparison rates.
- Advertised Comparison Rates are not available for loan combinations or any loan that includes an evergreen interest-only facility.
- Advertised Comparison Rates do not include discounts and cash-back deals which can radically reduce the real cost of your mortgage.
Of course, time and indeed the law have moved on, and a few years ago the government also introduced a Key Fact Sheet (don’t get me started on that), together with a Personalised Comparison Rate.
While the addition of the word ‘personalised’ may give some comfort that this rate is somehow more individual, it’s important to understand that every Personalised Comparison Rate also carries the same unascertainable fee exemption crafted earlier this century. While you do get a neat little rate, thousands of dollars in fees and charges that you will pay and rebates you might receive are lawfully omitted.
That might be fine if you knew what was what; however, there is absolutely no breakdown of the fees that have been included, and, equally so, there’s no estimate of the big fees you are likely to be charged, even though your lender could quote them if required.
It might also be fine if the regulators who police the law had enough resources to police it, and the law itself actually gave you some protection, but they don’t and it doesn’t. So, truthfully, you have no idea of how personalised one rate is compared to another. New name. Same dog. Old tricks.
It is common that loans with lower comparison rates are $20,000, $30,000, or $40,000+ more expensive than loans with higher comparison rates – and that’s on a $350,000 loan, over the same loan term. Seriously.
Nonetheless, if you still believe in comparison rates, there are three important things to remember:
- The bidders control the numbers that go into the formula.
- The six o’clock swill.
The moral of the story is take control to profit. If you don’t, someone else will, and their profit is your loss.
TIP 4 Get it in writing
This might sound pretty basic, but it’s an important point. It constantly amazes me how many people I’ve spoken to over the years who not only know very little about the loan they have but also have next to no summary information on any deals they compared before arriving at their choice. Even fewer checked whether the information they were told during the sales process (pre-application) was the same as the deal they actually signed up for in their loan contracts.
There are five things you should ask for and get in writing before you even shortlist a deal (see box below). It doesn’t necessarily need to be written in blood; email’s fine, just as long as you can get back to it at any time and you know who it was that gave it to you.
Ask for the facts about...
TIP 5 Understand the ‘Mum Principle’
- Establishment charges: Any and all fees, disbursement or charges you are likely to pay, up to and when you settle your loan, including what they are called and how much they are.
- Ongoing charges: The interest rate(s), including any fixed or introductory term in which it applies, and any and all monthly or annual maintenance fees, including what they are called and how much they are.
- Exit charges: Any and all fees, disbursement or charges you are likely to pay when you exit your loan, whether or not it is because you refinance in a few years’ time or pay it out completely in the longer term. Make sure to find out what each charge is called and how much it is.
- Cash-backs: Any and all one-off or monthly payments your bidder makes to you, including what they are called, how much they are and when they will occur. This one is optional as not all lenders or brokers pay cash-backs, but if they do, you should make sure to include them in your TIC calculations for each deal.
- The final thing you want to know and the sentence you should include in any enquiry is: “Please tell me the maximum allowance I need to make for any fees and charges to establish this loan and which you have not already told me about”.
To get the best indication of the concessions for which you are eligible (such as fee waivers, rate discounts or rebates) as well as the charges you will have to pay, it’s a good idea to at least explain your borrowings and the value, type and location of any property you will offer the lender as security.
It might be obvious, but, as a general rule, the more information you can give about your situation, including income, employment and expenses, and the more deals you can compare, the better your results will be.
For most people, reading about maths in a magazine isn’t the most riveting experience; however, it’s important to at least lay out the mistakes that cause most borrowers to unwittingly lose money through poor comparisons.
Let’s start with the most important point, based on what I call my ‘Mum Principle’, which means you should make sure you put the same amount of money into all loans being compared over the same comparison periods, and the initial loan drawings (money you keep or disburse) should be the same.
Let me explain. Say we need $350,000 to complete a purchase. We have found two identical mortgage deals with a rate of 5% for evergreen interest-only, and our loan term is 25 years. In fact, the only difference is where we get the loan from, and that Loan A has no establishment fees while Loan B charges $1,000 in valuation and settlement charges.
We clearly know that Loan B is more expensive than Loan A, right? However, the important question is, just how much more expensive? If you’re the mathematical type that likes a challenge, take a minute to scribble some calculations. If you’re more of a gut feeler, take a guess and write it down too.
For the record, common answers are that Loan B is $1,000 more expensive, or about $2,000 more (doubling the actual fee to allow for interest). Both are quite wrong.
The Mum Principle tells us that money neither grows on trees nor pops out of thin air; it has to be created somehow, and every time we do so it has a cost that we need to factor in.
This particularly affects (a) your repayments and (b) the individual lender set-up costs.
To get this right, you need to:
Loan Free Calculations (Click to enlarge)
- Identify your Base Loan Amount, which is the cash amount you want to have or be able to disburse when your loan settles. That amount will be the same, regardless of which loan or lender you go with; however, it will almost never be the actual loan amount in any comparison. In the case of both loans, our Base Loan Amount is $350,000.
- Identify each deal’s establishment fees and charges, including the very first annual or monthly fee if there is one. To keep it as simple as possible, let’s call those fees and charges the Deal Establishment Fees. Although you may not actually wind up doing it in real life, you should add the Deal Establishment Fees to your Base Loan Amount to enable comparison of each respective deal. What this does is assign a cost of money to any establishment charges, creating a more reliable comparison.
So the difference between the TICs of these two loans is $1,250, right? Wrong. So far the interest cost is $1,250, but there are two other costs that have disappeared out of the comparison. The first cost that went missing is the Deal Establishment Fees, so add $1,000, taking the difference to $2,250 for now, but that’s not the end of it.
The second magically disappearing cost is the cash flow impact caused by the higher repayment for Loan B. If you ignore this, you give Loan B an unfair and dishonest advantage. To correctly compare these loans apple with apple, you should add $4.16 a month to your repayment for Loan A.
After all, Loan B takes $1,462.50 out of your pocket each month, so again, using the Mum Principle, so should Loan A. The result is that each $4.16 payment erodes the balance of your loan just like any other extra repayment does and it also reduces the interest cost of Loan A. The combined effect, assuming we take the same cash out of each loan and make the same loan payment to Loan A and Loan B, means that the TIC for Loan B is $5,962 more expensive than Loan A.
Now it’s not likely that you would model a 25-year loan as interest only, which pushes the impact up (unless that is your actual view). However, at the same time, we are using a relatively small fee difference on a below-average loan amount and at well below normal interest rates, which pulls the impact down.
The point is, you should calculate TICs for each of your options and take realistic exit points to see what the actual cost implication is. If you are making cost comparisons over longer terms of, say, seven years or more, you should learn more about Net Present Value, a common method for modelling the relevant value of long-term costs in today’s dollars.
Importantly, if you are shopping for your loan properly, you are likely to be looking at more than one loan, ideally from multiple sources, such as a few mortgage brokers and a handful of lenders that you probably wouldn’t find through a broker, as well as a few that you definitely wouldn’t find through a broker.
That makes it impractical to even bother basing the comparison on the deal with the highest current impact on your cash flow. No doubt the best way to deal with standardising TICs under the Mum Principle, as well as to plan sensibly for your own peace of mind, is to equalise the payments for all loans based on your budgeted loan payment.
As a guide, that amount should take into account what you expect to pay today, allow for a few interest rate increases and also a request by the lender that you start paying your loan as principal and interest.
TIC is best calculated using spreadsheet software, and Microsoft Excel is, arguably, one of the most common out there. If you, or someone you trust (like your partner, mother, father, brother, sister, aunt or uncle), are just a little bit comfy using Excel, I recommend you Google a tutorial on “How to create a mortgage calculator in Excel”. If that seems too hard, have a quick chat with your accountant or an independent mortgage advisor for professional help.
You get what you settle for
It is important to remember that cost is only half of the value equation. Match or fit is the front end of business, because getting something that’s cheap and doesn’t work properly is still a dud deal. While getting a deal that costs less is what we’ve talked about here, getting one that hits your requirements is the pointy end of business. There are likely to be dozens of deals out there that meet your needs, and those deals are your starting point. If you’re only looking at six or so, you are probably selling yourself short.
The simple fact is that the more bidders and deals you impartially and carefully compare, the better your results will be, which might mean you need to kiss a lot of toads before you find your prince (or princess). In today’s hungry mortgage market, the power to get the best deal for you, if you want it, is within your grasp; but no matter what, you will always wind up getting exactly what you settle for.
Michael Lee is the author of “Mortgage Free Debt Free” and the founder of flongle, the world's first fully independent mortgage contest platform.