Home Loan Interest Rate Strategies

I’ve had a tonne of emails recently asking me to post more often – I’m sorry guys, things have been flat out but I’ll get posting more regularly now! One email that probably spurred me on to this post was a question relating to fixed or variable interest during these times of declining interest rates and whats best!? It’s a good question to ask and i’ll try and address a bit of now.

You see interest on home loans is compounding interest – as no doubt many of you home owners know – typically over a 30 year loan. This means that the interest adds up each year and ‘interest is applied on interest’ – in addition to being added to your principal basically. The amount you are going to pay back in interest, is more than what you will actually borrowed in principal, and so if you borrow $500K at 10% interest then in your second year you will be charged on $550K (assuming you paid no principal off in the first year). This is known as – what I have termed – “The 2.1 Principal”. That is, you are going to pay back double and a bit on the amount you borrowed as a rough approximation across the life of a typical home loan.

So on a $520K home loan at 7.5%p.a for the next 30 years – you are paying back a whopping approx $788K in interest alone! Or $1.308 mil over 30 years for interest and principal – “The 2.1 Principal”. Yes, it sucks and this is why the bank earns so much money. So how can we tackle this problem and reduce our overall cost ? Well there are a number of tricks:

1. Change your payments to fortnightly

Yep, this is the oldest trick in the book. There are 26 fortnights in a year, and only 12 months – so you are actually gaining extra payment cycles per year which can assist you in paying off the loan without you really even knowing. The amount you are paying back is faster so the overall number of payments shoots up and reduces the amount of interest building up. If you aren’t on fortnightly payments (unless there is some sort of taxation strategy at play) then you should be!

2. Don’t decrease payment amounts

This is without a doubt the biggest saver across 30 years. You know that extra $50 you get weekly from the Government interest rate cut ? Don’t spend it on that new LCD. Simply put – the more you can shove back into your home loan – the less interest you are giving the bank – and the more you are “forcing” yourself into saving. You have to get used to setting up your fortnightly budget and sticking to it – don’t decrease repayments as it’s going to hurt you substantially in the long run. So this means if an interest rate cut comes along – don’t spend this cash - rather keep your pre-interest rate cut payment cycle going at it’s current rate. This will drastically cut the life of your loan and not really impact your lifestyle as you were managing this repayment when interest rates were higher anyway?

3. Fixed or Variable or Both?

Yep, it’s always good to check out your options when interest rates go low. A split “fixed-variable” home loan is always a good bet to ensure that you can lock-in some “upside potential” when interest rates increase or decrease. That is, when the economy starts moving again and interest rates increase – your fixed “leg” of the home loan protects you from this adverse movement and your variable “leg” is less impacted by the increase. Equally, if you were a little overzealous with your fixed rate lock-in – then when interest rates come down, your variable side helps you out and your fixed leg doesn’t.

Of course, if interest rates are plummeting then it’s always good to check out the cost of fixed rate loan in it’s entirety. Although, as many famous investors have said “Don’t put all your eggs in one basket”. Fixing an entire loan is usually only beneficial when the cash “base” interest rate is really low. For example, people who locked in rates at 8% a few months ago would be kicking themselves, because now they have a minimum 3 or 5 year fixed rate that they cant get out of. Had they taken the “split” strategy – then things wouldn’t be “as bad.

As always, this strategy also depends on the nature of the loan and whether it’s for investment or ‘home living’ purposes. Many tax advantages exist for running higher interest costs and so forth – hence, the reason for interest only loans – so it’s not always the “best strategy” but rather one to get you thinking about. Also remember that “fixed loans” are priced by some very smart people at Banks who forecast future interest rate rises – so this is why the “fixed rate” is always so much higher than the variable. The Bank is adding in some “cushioning” to ensure that if interest rate change upwards, they are not adversely impacted in the short-term. This is also why interest rates are only ever priced for 3 or 5 year lots – as it’s far to difficult to forecast any further ahead for interest rate movements.

4. Super or Homeloan?

This is tough one and really dependent on a persons individual circumstances and current life cycle. Many people are going to scream at you “interest, interest, interest” and I am going to more than likely agree. However, you need to do the maths. If you superannuation is netting you a return which offers a more substantial incentive to decrease your monthly repayments to the absolute minimum level required by your bank, so that you can pump residual cash into your super – it’s a valid strategy. You have to look at the combined benefit of the taxation savings and the performance of the *real* (minus inflation) superannuation return to find out whether this is worthwhile.

It is worth it ? That’s a life, maths question that you should check with your financial planner about.

5. Aggregate Loans and Be Aggressive

Yep, folding multiple home loans into one is another good way to reduce payments and get an ‘accumulative’ interest rate which is lower. This is all “debt reduction” companies do that you hear on the radio – they basically tell you

“stop spending, lets fold all your debt into one facility and get a lower interest rate so you can pay it off faster”.

Of course, most of the time people in this situation are in high interest debt facilities so they will hook you up with an interest plan that earns them trailing commissions and is lower than what you were paying – but not as low as what you could get – so you think you win. This is how they make money.

My question? Why pay these people when you can do this yourself. Approach a bank or credit house (assuming your credit rating isn’t too bad) and ask about transferring to them. Find out all related fees and charges such as “transfer balance fees” and so forth. Do the maths and you may find it is more beneficial for you to shove everything into one loan and pay an aggregate rate on this loan, than pay a whole lot of separate loans.

Remember, you don’t owe your current bank anything and if they want to keep you – even if you have been with them for 30 years – tell them to get their pen out and start slashing off 0.50% from the rate they give you. Always go with the best rate unless there is some other incentive for you to stay at the bank.

Conclusion

Different strategies for different people. Most importantly is that you really spend a night doing some calculations to find out ways to reduce, and lock-in, reductions during periods of interest rate cuts and economic recession. If you have a financial planner, ask them to do some maths for you (what are you paying them for!?) and get some benefit from all the doom and gloom.

Of course, it always comes back to your personal willpower to pay off debt fast – the quicker it happens, the less interest you pay and the more you can enjoy a debt free life.

That’s about it for this post – email me as always via the contact page with your questions!