Even professional economists are not always able to predict events that can significantly influence interest rates.
So how do you reduce the impact of big upward swings in mortgage interest rates? As well how can you get some benefit if interest rates decrease?
I researched this question in 1997 and found very little information available on how I could protect my interest rate exposure.
DOLLAR COST AVERAGING
What I did understand was how to protect myself as an investor in stocks. By using a strategy called Dollar Cost Averaging. The strategy commonly employed to minimise investment risk when investing in stocks.
Dollar Cost Averaging was a valid risk minimisation strategy for investing.
An investment strategy whereby you invest a fixed dollar amount on a regular basis. Usually that’s monthly, to purchase stocks or stocks in a mutual fund. If the share price declines at one of these regular intervals when your fixed dollar investment is made, you receive slightly more stocks for the same fixed investment amount. If the stock price is up, you receive slightly fewer stocks.
That simply minimises the risk of buying all the stocks at peak levels as they are not all purchased at the same time.
So I thought how I could apply the same principle to borrowing?
This gave rise to the concept of Interest Rate Averaging.
INTEREST RATE AVERAGING
Interest Rate Averaging is a method that many property investors now utilise as an effective interest rate risk management strategy. Achieved by splitting mortgage debt into several smaller loans and then taking different interest rate terms on each loan.
EXAMPLE
On a $1,200,000 mortgage, you can split this amount into six separate $200,000 loans and take differing interest rate terms on each loan.
Loan 1 $200,000 Variable (Floating)
Loan 2 $200,000 Fixed for 1 year
Loan 3 $200,000 Fixed for 2 years
Loan 4 $200,000 Fixed for 3 years
Loan 5 $200,000 Fixed for 4 years
Loan 6 $200,000 Fixed for 5 years
You would then have an average interest rate on your total borrowings. Should interest rates increase by say 3% p.a., your average interest rate will only increase by 0.5% p.a.!
At the end of each twelve-month period, $200,000 of debt will expire from its fixed interest rate. Each year you will only need to decide whether to float or fix that $200,000. This is a much more manageable decision to make than whether to fix or float the total loan amount.
INTEREST RATES WILL CONTINUE TO BE VOLATILE
Interest rates will continue to be volatile in the long term. Is it worth risking a lifetime of investing by not having a strategy to minimise your interest rate risk? Many people opt for a variable interest rate (when short-term interest rates are low). Sometimes early repayment penalties of several thousands of dollars will be incurred to break fixed rates to enjoy a lower short-term rate. The intention is usually to watch interest rate levels and take a fixed rate if rates start to increase. This appears to be a somewhat short-term solution to a long-term (mortgage) commitment.
For example, if interest rates start to increase and we take a fixed rate, we may find a few months later, that rates are back down. Worse still they may be considerably lower than when we (wisely) decided to fix the rate!
Interest Rate Averaging offers many advantages including:
- Less interest-rate risk.
- Less stress when deciding on whether to fix or float.
- The opportunity to gain some of the benefits of reducing rates (a portion of our debt will be on a floating rate, so if floating rates decrease so does our overall interest cost).
THE DOWNSIDE AND UPSIDES
The downside of Interest Rate Averaging, is that each time we take a fixed rate, a bank re-documentation fee may apply due to re-disclosure requirements. That fee obviously affects our costs (effectively increasing our true interest rate), but the benefits of Interest Rate Averaging could outweigh this cost.
Interest Rate Averaging is not a perfect science, but it goes a long way to relieving the difficult decision of whether to fix or float our mortgage. At the same time minimises the risk of interest rate exposure.
Content source: Grow RICHER with the Property Cycle
Additional information: Is the Property Cycle Different This Time?
