Interest Rate Averaging

28 August 2015

Interest rates are at historical lows.  Most expectation is that rates will drop even further but the question is how long will it take to reach it’s lowest and what will that lowest rate be?  The answer of course is that we don’t know.  So how do you structure a loan today?  Do you fix or float?  If you fix how long for?

Floating at present is the most expensive at around 6.25%.  It does provide the flexibility of being able to make lump sums or increase your loan repayments without incurring any extra costs.  With forecasts expecting to see further drops it is regarded as one of the preferred options to keep open the opportunity to fixing at lower rates at a later date in the near future.

Fixed interest rates offer the security that your loan repayments will remain the same for a certain period of time.  Even if interest rates rise your repayments will remain the same on a fixed term.  However the fixed interest loan is more restrictive.  If you increase your loan repayments or pay lump sums off your loan you can be charged break costs and other penalties.  If rates drop you are still stuck on the rate that you fixed it at.  

In order to obtain the security of a fixed loan PLUS the flexibility of a floating loan many home owners are opting to have a combination of the 2.  If there are any spare cash reserves these can be used to reduce the floating loan but if and when the interest rates rise they also have the security that part of their loan repayments will remain the same.

However there are even more opportunities to maximise the benefits of these types of loans in the current economic climate.

If you fix short term (eg 6 months) the rates are lower than floating.  At the end of that term it is expected that the longer term rates would be lower and therefore you could lock in to a lower fixed rate for a longer period than is offered today.  However this is speculation.  We expect rates to be lower then but it’s not guaranteed.  

Fixing longer term eg 3 – 5 years offers more security.  Rates are still well under the average 8% and close to record lows.  Generally the fixed 5 year rate is around 5.6%.  So they are still considered relatively cheap.  But long term fixed rates are higher than the shorter term fixed rates. Plus it is also often difficult to ascertain what our needs will be in the next 5 years as opposed to a shorter 2 year forecast.

One strategy that property investors use for large borrowings is the strategy of “Interest Rate Averaging”.  This is where some borrowings are put on a variable rate with the remainder of the borrowings to be put on short, medium AND long term interest rates.  The advantage of this is that there is still flexibility in the floating loan.  There is some short term certainty and flexibility with the shorter term fixed rates and more certainty with the longer term interest rates.

This spreads the risk of having all borrowings on the same terms.  It means that not all borrowings will come off their fixed rate in a potentially higher interest rate market.  Yet if interest rates dropped there is also the opportunity to take advantage of this.  

This strategy does not necessarily work in all economic conditions but there are definite merits in at least considering a more complex and thought out structure.  You can discuss this with your Mortgage adviser to try and take advantage of this climate and the opportunities it is providing.

 

Published In Whakatane Beacon

This post was written by

Trish Marsden - who has written 96 posts

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