Cut the mortgage to size

Mortgage rates are falling and the response is predictable - we'll say thanks very much and borrow even more.

But there is another way to respond to this week's interest rate cuts: use them to get out of debt sooner.

Some banks have already reduced floating mortgage rates, and short-term fixed rates too, in at least one case, after the Reserve Bank this week cut another 0.25 percentage points off its official cash rate.

It was the second time in six weeks that the central bank has cut rates and another cut looks almost inevitable.

In the meantime, rates are down again and there's a chance to become debt-free sooner. To achieve that goal, borrowers have to do nothing except resist the temptation to reduce their repayments in response to the latest cut.

While 0.25 percentage points doesn't sound like much, and it doesn't make a big difference to the monthly or fortnightly mortgage payments, it can make a huge difference to the time it takes to get out of debt.

An example: if you'd borrowed $150,000 last week from one of the major banks at, say, 7.6 per cent, you'll need to repay about $1118 a month to be debt-free in 25 years. Assuming your lender matches the Reserve Bank's latest cut, and reduces its rate to 7.35 per cent, the required monthly payment will fall by a whole $24.

But if you don't cut your monthly payment, and keep it at $1118, the lower interest rate means you'll be out of debt 18 months sooner, and save more than $20,000 in repayments over the 25 years. That's not a bad return on a 0.25 percentage point cut, but it gets better.

This week's cut wasn't a one-off; the Reserve Bank has now cut rates twice this year and the bank's Governor, Alan Bollard, said on Thursday that another "modest reduction" was likely.

The three cuts will add up to at least 0.75 percentage points, although some economists are predicting the bank will eventually have to cut more than that.

Another example: if you'd borrowed that $150,000 just before the Reserve Bank started cutting rates in late April, you would have paid about 7.85 per cent at one of the big banks. Monthly payments over 25 years would have been about $1143.

Cut the interest rate by 0.75 percentage points, which will probably soon be the case, and leave the monthly payments alone, and that $150,000 will take just over 21 years to repay, with a saving of over $50,000.

In real life things aren't so simple. For one thing, interest rates aren't likely to fall then stay low for the next 25 years. Eventually they'll rise again - a good argument in itself for taking advantage of any interest rate cuts now.

But whatever happens, the basic principle remains: even an apparently small cut in the interest rate can have a major effect over the long term, especially if your mortgage has many years left to run.

The easy way to work out the potential savings is to use one of the many on-line mortgage calculators. The banks all have them, or try the one on the Retirement Commissioner's website (www.sorted.org.nz, click on "managing debt'). Or, next time the bank tells you rates are falling, ask it to work out the effect of leaving your payments unchanged.

As well as the obvious arguments for getting out of debt sooner - because it gives you more money to spend on other things, because it feels good - there's the less obvious fact that even today's low mortgage rates aren't as cheap as they appear.

At a mortgage rate of 7.35 per cent and an inflation rate of 2 per cent, at a guess, over the year ahead, the "real" interest rate is still above 5 per cent. Even back in the crazy days of the 1970s and 80s, when interest rates could be well into double digits, the real rate was often lower than it is today.

All of which means that, while today's "low" interest rates mean you can borrow more and/or pay less than you might have done in the past, inflation isn't shrinking the real cost of those payments as quickly as it did when inflation was higher.

What happens next? Seven out of eight economists polled by the Bloomberg news agency after this week's cut expect another reduction at the Reserve Bank's next scheduled interest rate announcement, in late July (the eighth expects it in September).

That will trim rates by at least another 0.25 percentage points, although some economists predict they will go even lower.

Cuts in the official cash rate will have most impact on floating rate loans; fixed rates are more influenced by overseas trends, though those could also go lower.

But if you do use lower rates to repay your debts more quickly, you'll be going against the trend.

Reserve Bank figures show our mortgage debts grew by another $3.2 billion in the first four months of this year. At the end of April we owed about $77.6 billion on our mortgages, an increase of almost 11 per cent in the space of 12 months.

* To contact Personal Finance Editor Mark Fryer write to: Weekend Herald, PO Box 32, Auckland. Email Mark Fryer. Ph: (09) 373-6400, ext 8833. Fax: (09) 373-6423.