A Reserve Bank guide to avoid the bumpy ride

The Reserve Bank of New Zealand has released a new edition of its popular guide to managing the risks involved in saving and investing.

‘Upside, downside: A guide to risk for savers and investors’ was commissioned by the Reserve Bank of New Zealand and written by investment commentator Mary Holm for ordinary New Zealanders.

Since its original publication in 2012, the guide has received two significant revisions to take account of changing KiwiSaver rules and other developments.

‘Upside, Downside: a guide to risk for savers and investors’ is available free of charge, only as a downloadable PDF from the Reserve Bank website (www.rbnz.govt.nz)

The following is an extract from the Guide:

All investments come with some risk.

This small book guides you through the different types of investment risk, explains why investment risk is not necessarily a bad thing, and gives tips on how to reduce risk.

High Return at Low Risk

Before you launch into investing, consider the one financial move that offers what seems to be the impossible: a fairly high return and virtually no risk.

It applies if you have a mortgage or other loans, such as credit card debt.

The move: put your savings into paying off debt as fast as possible.

Start with high-interest loans such as credit cards and hire purchase.

Paying off a loan on which you are being charged 20% interest improves your wealth in exactly the same way as receiving an investment return of 20% after tax and fees, with no risk.  It does not come much better than that!

Reducing Mortgage

Once you have got rid of high-interest debt, it is also good to reduce your mortgage.

This is equivalent to making an after-tax return on an investment that is the same as your mortgage interest rate.

So, if you are paying 6% on your mortgage, repaying it is like earning 6% after fees and tax. This is a deal you won’t be able to beat without taking some risk.

Aside from equivalent returns, repaying debt is good ‘insurance’ against hard times.

If you find yourself facing ill health, redundancy or a forced early retirement, having a low mortgage or a mortgage-free home makes it much easier to cope.

And if a family member needs financial support, having low debt will make it easier for you to borrow more if necessary.

Repaying debt is also simpler than investing.

You don’t have to select an investment or monitor it.

Faster Repayment

How effective is repaying your mortgage faster than necessary?

Let us say that you have a $200,000, 25-year loan, at 6%. If you pay back an extra $50 a month, you will save about $17,500 in interest over the life of the loan, and pay it off two years early.  If you repay an extra $200 a month, you will save more than $54,000 in interest and pay the loan off in less than 19 years.

For other amounts, interest rates and mortgage terms, use one of the internet mortgage calculators at www.sorted.org.nz, www.theshapeofmoney.co.nz or www.interest.co.nz.

Each site offers different features. If you receive a lumpsum of money, such as an inheritance, bonus or redundancy payment, it is also a good idea to use that to repay debt – perhaps after using a small portion for fun!

Bank Penalty

Note that with fixed rate mortgages, there is usually an early repayment penalty. While some lenders permit you to increase your regular mortgage repayments by a relatively small amount without incurring that penalty, most will not accept large regular payments or lump sum payments without penalty.

If you face a penalty, it is often better to put extra mortgage repayments in term deposits and transfer the money to loan repayment when the fixed term ends.