Is the lowest interest rate really the best option?

How’s this for a scenario:

Bank Manager: Hi Mr & Mrs Customer, here are the interest rates we have available for you… (banker presents a list of rates). How long would you like to fix your loan for?

Customer: Hmm, which one should we take?

Bank Manager: Well, we have a special on our two-year rate of 4.19% at the moment, that’s the lowest.

Customer: Lowest sounds good. Lock it in, Steve.

Now I know we all like a good deal. But, is this really a good deal, or just the perception of one? What would happen if rates increase for these customers soon after they fix? Let’s say there was a sharp rise in rates following another Global Financial Crisis (or similar), and interest rates went from 4.19% to 6.19% over the space of two years.

When Mr & Mrs Customer come to refix, what will happen to their repayments?

Well, a $500,000 loan at 4.19% would cost approx. $2,442 per month.

The same size loan at 6.19% would cost around $3,059 per month.

Can they afford an increase of more than $600 per month? Have their circumstances changed? Have they started a family? Has their income increased in line with living costs?

If instead Mr & Mrs Customer had taken a longer term at a slightly higher rate, they may well have come to refix many years down the track, when interest rates were low again. But who’s to say which term was the right one!?

For anyone from a first home buyer through to a seasoned investor, an increase in interest rates at the wrong time can be devastating. And it’s something almost every borrower will face at some point.

Now unfortunately, my crystal ball is about as foggy as everyone else’s when it comes to predicting the future of interest rates. Yes, we can all look at trends and market conditions and the media and other speculation. But there’s only one thing that we know for sure: Interest rates will go up, and they’ll go down. The un-answerable question is WHEN.

So, what if we change the question? What if instead we ask: Since it’s inevitable that we’ll face an increase, what’s the best way to reduce my exposure when it happens?

Well THAT, my friends, is where we bring in a wonderful little concept I like to call “Interest Rate Averaging”.

HEY!! DID YOU JUST FALL ASLEEP ON ME!!?? I don’t blame you, it does sound pretty boring. But hear me out.

Most people don’t know they have the ability to split their lending into many different fixed or floating portions.

You can take your $500,000 loan and split it up however you like; some on a 1 year, some on a 3 year, and some on a 5 year fixed term, if that’s what tickles your fancy.

Or any other combination you choose. 2,3 & 4 year terms; 3 & 5 years; 1 & 4… It’s up to you.

The idea here is that you reduce exposure to the ups and downs when your fixed terms expire, because the amount that’s going to face the change in rate is smaller – say, $150,000 instead of the whole $500,000.

This can help you manage smaller changes more easily, and over time stabilise the average rate you pay over the life of your loan. Which in turn can save you a lot of money and, perhaps more importantly, stress.

To find out more about this and get a clearer understanding of how it can work for you, contact your INNOVEST adviser today and we’ll show you all the options. Or just give us a call on 0508 INNOVEST. Remember our service and advice is FREE, so you’ve got nothing to lose, and everything to save.

P.S. Just after writing this, I’ve heard speculation that interest costs may increase by a third over the next year. For someone paying a mortgage payment of $2,500 per month that could mean an increase to $2,920 by next year.