So we're going to talk about interest rate averaging, and what's the best way
to structure your mortgages so that you're not going to get stuck on high rates
for a long period of time, and then you're also not going to get
caught out selecting a one year rate, and then the next year, the rates just
skyrocketed and you're going to be exposed to that big change. So a lot of people
get confused, should I pick one year? Should I pick two years?
Should I pick a three-year rate? How should I structure my mortgages?
And how do I make sure I'm always getting the lowest rates? And so,
general best practice is called interest rate averaging. And so what we get is
less risk, more reward. And what we're trying to do is measure
against having some certainty and accepting there's going to be a little
bit of uncertainty. If I say to you, "Hey, look, let's pick a one year rate,
let's go for what, 4.1%." And then next year after that expires,
it's up to 6% or 7%, what's going to happen is your interest rate
expenses are going to almost double. So that's not going to be a fun time.
And what we're trying to do is split that up so that you don't have that uncertainty
of not knowing what the rates are, and having unexpected costs,
but you got the benefit of having the lower rates for a period of time. And so,
this split is called interest rate averaging. And just the example
we're going to look at today is $600,000 of lending, and we're going to put some
on 1 year, some on 2-year, and some on 3-year. And so we're going to put
$200,000 on each term. So we're going to break it down.
So this is 2018, 2019, 2020. And so if you took your $600,000 and you
put all of it on a 3-year, 4.7 rate, this $200,000 of lending would be $9,400
per year for this $200,000 of lending. And if you did that for 3 years for the
whole $600,000, so what that means is if you fixed all of your $600,000
on a 3-year, 4.7% rate, it's going to cost you $28,200 in interest expense annually.
So this is certainty
of 3 years on 4.7%. But you say to me, "Hey, look,
I've seen this 4.1% rate, I'd like to take advantage of that."
So what I would say is, "All right, let's split your $600,000 into 3 periods,
3 portions, $200k on 3 year, $200k on 2 year, and $200k on 4.1%
for one year. And so what does that look like? Well, in 2018, your interest expense
is going to be $9,400 for the $200k on the 3-year portion, $8,600 for the 4.3%,
2-year portion of $200k. And then that 4.1%, $200k is $8,200.
And so what does this mean? Your first year, you're only
going to pay $26,200. And so, instead of paying $28,000,
you pay $26,000. So in your first year, just splitting the mortgage up,
you're going to save $2,000, and you can put that money into your
principal repayments or go on holiday or spend it however you want.
Now, the certainty of having the three years does mean it costs you more money.
And that uncertainty of picking all of this one year rate means you don't know
what you're going to have to be faced with in year two and year three.
And if you wait for all two years, you wouldn't know what's going to be
in year three. But the interesting thing to keep in mind is, let's say this year
one rolls over, and now you've got another $200k portion and you've fixed it
for 1 or 2 years, this would have to be…even if this 1 year rate was 4.7%,
then this is going to be $9,400, and you add these up,
you're still going to save $800. So you can see that even if the one year
interest rate spikes quite a bit, that you're still going to save money
doing interest rate averaging. And there's a couple
of different benefits. Firstly is, obviously there's annual savings and the
protection of not being exposed to massive swings and interest rate changes.
But also what it means is, so you'll fix this again for another one
or two years, and when this one expires, you'll fix it for another
one year, what happens is, everything is probably going to come
up to be due at the same time after three years. And it means that you can go
and get another cashback if you're open to change your bank. So cashback at the
moment for $600,000 might be, you know, let's say $4,500, and by having it all
come off at the same time, that means the break fees are
going to be zero. Well, and there might be a discharge fee or something.
But doing the strategy gives you good flexibility. And what it means is,
if we have a look at this graph quickly, instead of having big swings and writes
every three years, and it's unpredictable, what we're trying to do is save money
every year by having small portions coming up, instead of having a big portion
fixed for a long period of time. And making these little, small
increments makes it much easier to get your top ups approved and, like, gives
you more, you know, negotiation power, because it means that list of your
mortgage is going to be liable for break fees, and you get to talk to your mortgage
advisor or banker a little bit more often, which despite the frustrations is actually
probably an advantage. So, hopefully I've explained interest rate
averaging well. I'll try and summarize the points below.