How to structure your home loan using interest rate averaging.
If you wanted the cheapest possible interest rate today, it’s likely you would fix your whole mortgage for one year. Check out rates on our pricing page. However, this isn’t necessarily a good idea for a few different reasons. If rates next year were significantly higher, you would then have to refix your home loan at a much higher rate and face a massive increase in your interest expense costs.
Lets look at a quick example;
If you fixed a $400,000 loan at 4.2% then the interest expense will be $16,800 for the first year.
For the 2nd year you will have to wait and see what the rates come out as, it might be lower, around the same, or higher, but you are taking that risk knowing this.
If you fix on 2yr for 4.4% then it will be $17,600 annually for the first 2years. There is complete certainty of the cost of your interest expesnes which are slightly higher for the first year than they could be but you do not want to risk being exposed to higher rates half way through the 2 years by taking the 1yr rate.
But, if you split the loan and put $200,000 on 4.2% for 1yr and $200,000 for 4.4% for 2yr, you can apply interest rate averaging. This means you lock in some of the benefit of the lower rate for 1yr and get the certainty from having half the loan locked for 2yr. If after 1yr your $200,000 comes to be renewed and the rates have dropped, then you get the benefit, and if they have gone up you only have half the cost because you still have half fixed for another year.
Interest rate averaging will smooth the costs for you and make it easier to manage fluctuations in interest rates. You can see from the graph that rates can swing up and down a lot!
You can read more about rates here:
Likewise, if you wanted the ultimate in long-term security you might choose to put your whole loan on a 5yr rate. This is great, as long as interest rates don’t fall. If they do, you’ll be stuck on a high-interest rate. Most mortgage advisers will suggest a combination of various fixed terms and a floating portion to minimize risk. This is called interest rate averaging and protects you from making mistakes.
It’s worth considering the best way to get the best of both worlds taking 3-4 portions, and fixing them for different terms (1 year, 2 years, and 3 years for example). Over time, you’ll get an averaged interest rate and have the opportunity to review a significant portion of your mortgage every year or two.
If you want to reduce risks, have flexibility, and get the most of discounted rates without to much exposure to massive rate hikes, then talk to us about interest rate averaging.