What is a Home Loan Buffer?
Simply put, a home loan buffer is savings set aside specifically as a back-up plan for anything that may impact on your ability to pay your home loan, or to help manage the impact the home loan has on your lifestyle in the future. If you are enjoying the benefits of a low fixed rate you may choose to take advantage of the remainder of your fixed rate period to build a buffer to help you manage higher repayments when the fixed rate ends.
It’s a great way to protect yourself from future changes that may not be so beneficial. When circumstances change, like sudden hikes in interest rates, a job movement or any other unexpected event that increases living costs or commitments, borrowers can find themselves stretched. A buffer can provide peace of mind and act as a support should your financial circumstances change and you find yourself requiring additional cash flow.
How to build up a buffer
To build up the balance over time, calculate your repayments at 1% or 1.5% above your current rate and put the difference towards building up your buffer.
Repayments on a home loan of $ 600 000 at 4.5% are $ 702 per week. At 5.5% repayments would be $ 786 per week. Saving $ 86 per week will allow you to build a buffer at a rate of $ 4368 per year. If we assume that rates are stable for 2 years and then rise suddenly from 4.5% to 7% (much like the rate rises of 2022), you will have built up $ 8 736 in your buffer ($ 86 x 52 weeks x 2 years)
With an interest rate of 7% your weekly repayment would increase to $ 920 per week, representing an extra cash flow demand of $ 134 pw above the $ 786 pw you had been paying.
If your family budget can only handle an extra $ 60 per week without you making lifestyle changes you’d prefer not to make, you would be able to draw the difference of $ 74 per week from your home loan buffer. This would provide “cover” for a little over 2 years allowing plenty of time to adjust. It is important once you’re drawing on the buffer to start planning for what will happen once it’s used and/or how you will rebuild it.
Where should you keep your buffer
The best place to keep your buffer depends on the type of home loan you have and how your loan/s are structured.
Variable / Split Home Loans with Offset Accounts
The standout winner if you have a fully featured home loan is to use an offset account.
While the buffer is in your offset account, it is saving you interest on the mortgage and helping you pay it off sooner.
In the example above, let’s assume you build up your buffer over 4 years to $ 17 472 and haven’t needed to draw on it, either due to stabilised interest rates or because you’ve been able to absorb further increases into your budget. If you decide you have sufficient set aside and just leave that amount in your offset account, you will save approximately $ 40 000 in interest over the life of the loan and pay it off 12 months early.
Basic Home Loans (Redraw but no offset)
If you have a basic / low fee home loan with redraw but no offset you can build a buffer in one of two ways:
1. Making extra repayments into the loan
Building up a buffer by paying the extra amount into the loan, will have the same benefits as an offset in terms of saving interest and knocking time off how long it takes to pay off your mortgage. As long as you have redraw, you’ll be able to access the funds when needed.
However, there are a few things to watch out for:
It is important to check that your lender won’t automatically reduce your repayments because of the amount in redraw. If this is the case you may need to set your repayment amount to the repayment based on loan limit, and then add the extra, rather than allowing the bank to calculate the repayment required (as this will drop your repayment as your redraw increases to extend it back out to the full 30 year loan term).
Choosing this option does mean you will need to stay on top of rate changes and adjust your repayment amount each time rates change.
It is also important to check what the minimum redraw amount is that you can access at one time and whether you will be charged a fee. If there is a minimum, you may need to redraw enough to cover a few months and keep it in a savings account to help cover your repayments.
2. Use a savings account to keep your buffer in
Try to find an account that at least pays some interest, if it needs to be with a different bank you can always set up an automatic transfer to move funds back to your main account if and when you need to draw on them. Preferably, keep this separate to any other savings so that it’s not used for anything else over time.
Fixed Rate Loans
Generally fixed rate loans do not have redraw and cannot have offset accounts linked to them. You can usually pay up to $ 10 000 extra per year without penalty, but these funds cannot be accessed, so putting your buffer into a fixed rate loan will not work. In this instance, using a savings account to build up your buffer is the way to go.
If you sell and need to find a new home, there are a few things you can do to make the process smoother and minimise stress.
A further note on fixed interest rates…
If you are currently enjoying the benefits of a low fixed interest rate, it’s important to start planning now for when it ends. Ideally, paying the difference between what repayments will be on the variable rate and your current repayments into the buffer will not only help you adjust your budget, but also allow you to have a buffer in place by the time you’re back on a variable rate. It may not be practical to do this in one adjustment, but try to start with at least 50% of the difference and then 75% and 100% a few months out from the end of the fixed rate to that you’re ready for the change when it happens.
