Borrowing

Surviving interest rate increases doesn’t require a complete overhaul of your finances.

In fact, there is, at least, an upside for consumers as rates start to rise. Higher rates fuel competition between lenders, which have a greater range of rates to choose from when pricing their loans.

The re-entry of non-bank lenders will also spur competition. Non-banks obtain most of their funding from wholesale markets, which have been dysfunctional since the onset of the credit crisis.

Banks have drawn on funds from deposit customers to sell home loans, while many non-banks with no such deposits have been forced to sit on the sidelines. Below are some strategies to beat the rate rise.

1. SHOP AROUND FOR A BETTER RATE

Naturally, borrowers will be more inclined to shop around than they did during the financial crisis. “When interest rates are rising people will look around for the cheapest deal,” Cannex financial analyst Mitchell Watson says. “People will straight away look at the rate but they need to be careful to look at the fees behind it, which are taken into account in the comparison rate.”

Bare-bones loans (called basic variable mortgages at most institutions) are light on features but can offer big interest rate savings. For example, a 6 per cent variable rate $300,000 mortgage will have minimum monthly repayments of $1933 over 25 years.

Interest rates on professional packages can be up to 0.7 per cent lower than standard variable rates – and often include extra features such as a redraw facility or savings account.

Refinancing to a loan with features such as early repayment or an offset account can also help minimise the amount of interest you pay. But if you have a loan with extra facilities you rarely use (such as the ability to redraw funds from the mortgage, a line of credit or an offset account) it may save you money to drop these features and shop around for a basic variable loan.

Products are emerging such as Bankwest’s rate cap mortgage, a variable rate loan that promises not to exceed a given interest rate. It is an effective defence against rising rates but borrowers could achieve the same outcome by using the money to increase their monthly repayments and save interest over the life of the loan.

Another Bankwest product spurring competition is the interest rate tracker, which promises to undercut the big four banks’ average standard variable rate.

Some loans offer cheap honeymoon rates for introductory periods of between one and three years. On the surface these are great deals but it is essential to check the rate to which the loan reverts after the honeymoon period is over, as it’s often higher than other variable rate loans.

Don’t be afraid to haggle. Banks set their rates with enough headroom to wipe up to 0.7 per cent off the standard variable rate, so research loans from several lenders and ask each to name the discount they are prepared to offer.

2. MAKE EXTRA REPAYMENTS

Once you’ve locked in a good rate, the smartest way to reduce your interest bill is to increase the size of your monthly repayments. Remember the golden rule of money: a dollar today is worth more than a dollar tomorrow.

The more you pay off now, the smaller the outstanding the loan balance will be on which future interest payments are calculated.

“Most standard variable loans will allow you to pay as much as you want to,” Resi Mortgage consumer advocacy head Lisa Montgomery says.

“Consider taking out a loan with a redraw or offset facility so if you pay too much, you can access your cash again.”

When interest rates began to fall last September, many borrowers effectively ignored their new, lower rate and kept repaying their loan at the higher rate. Borrowers paying off loans assuming pre-crisis levels of interest will have saved thousands over the past year, and years off the life of their loan.

Rates are set to rise, so now is an ideal time to devise an extra repayment strategy – if you haven’t already. If worst comes to worst, you will have built in a buffer to protect yourself when rates do rise. Rather than fixing, RateCity’s Smith suggests you increase your repayments as if you are on a fixed loan (with a rate of, say, 2 per cent above your variable rate) but stay on the variable loan.

“You would strip out a huge amount of extra interest from the life of the loan. If you added $170 a month on an average $270,000 home loan, you’d be talking about $45,000 of savings on a 20-year loan term and a reduction of at least four years,” Smith says.

3. SPLIT YOUR LOAN INTO FIXED AND VARIABLE PARTS

Fixed rates are popular with borrowers who want to lock in a certain repayment amount and not have to fret about rising interest rates. But they rarely pay off financially.

Fixed rates are priced well above variable interest rates and there is typically only a distant possibility of variable rates going above the rate you fix at.

Fixed rates sometimes pay off if they are locked in well before rates rise. In the past some borrowers were lucky enough to obtain a fixed rate that was then surpassed by the variable rate after successive increases in official rates.

Arranging to have your loans split into fixed and variable sections is the equivalent of having a bet each way. A portion of your loan will be covered if rates rise, but you won’t be 100 per cent locked in if the variable rate doesn’t increase substantially over the fixed term.

Most lenders will agree to split loans into fixed and variable parts, but make sure your lender does not charge an unreasonable fee for the privilege. Most borrowers sign on to fixed rates for three years but one and five-year contracts are also common.

4. SELL YOUR SHARES AND PAY DOWN THE MORTGAGE

Many home owners are also budding investors, and Australians have one of the highest rates of share ownership in the world. Those who have recently taken out home loans should consider whether their share portfolio is really reaping dividends.

Some borrowers may find that ditching the share portfolio and plugging the money into their mortgage will actually save money in the long run and reduce the life of their loan, at which point they can dabble in the sharemarket to their heart’s content. Sadly, though, a strategy to rapidly pay down a mortgage does not afford the same “dinner party kudos” as a share portfolio, MultiForte financial planner Kate McCallum says. “People like to talk about their latest investment in stocks. It’s not as sexy to talk about paying down their home loan.”

There is an opportunity cost in investing in shares instead of using the money to pay off your mortgage, and your rate of return needs to take this into account.

Broadly speaking, investors on higher marginal tax rates will need higher returns on the sharemarket to justify investing instead of paying off the mortgage.

Investors on the top marginal tax rate of 46.5 per cent who earn more than $180,000 a year need a pretax return of 11.27 per cent on shares to be ahead of someone else who makes extra loan repayments. A middle-income earner on the 31.5 per cent marginal tax rate needs a return of 8.8 per cent.

“There is an element of risk associated with achieving those numbers. The markets can also deliver you negative returns,” McCallum says.

She cautions heavily indebted households to think carefully about the sharemarket. “The risks of something going pear-shaped are magnified if you invest further. If the sharemarket drops, you may not have the liquidity you need.”

5. CONSOLIDATE DEBTS

Let’s face it, for most of us, our home loan is not our only debt – we have multiple credit cards, car loans, personal loans and perhaps store finance on household items. Many of these unsecured loans charge ridiculously high interest rates.

Check your credit card statement. Are you still paying 20 per cent interest on purchases? If so, it may be time either to shop around for a cheaper credit card, consider refinancing the balance into a personal loan with a lower rate, or consolidate your debts into your home loan. At the very least, paying less interest on other debt will increase cash flow for mortgage repayments.

Any debt consolidation strategy must be approached with extreme caution. Ensure that your overall loan to valuation ratio remains below 80 per cent after consolidating debts into a home loan, otherwise lenders’ mortgage insurance will be imposed to protect your lender against the probability of you defaulting.

And consolidation can be a big trap because, if you don’t increase the size of your monthly repayments, you will end up prolonging the life of your loan, Montgomery says.

“A big mistake is consolidating and taking the debt out to a 30-year term. You must be prepared to change your behaviour. High interest-bearing debt may be eating into your disposable income. This won’t change by consolidating the debt.”

6. THINK BEFORE YOU LEAP

Don’t extend the term of your loan unless absolutely necessary. Opting for a 30-year term instead of a 25-year term may cut your monthly repayments but it increases the total interest bill for the loan by thousands.

Beware interest-only loans unless you’re really strapped for cash. Holders of these loans do not pay back any principal and therefore do not increase their equity in a property. These loans only pay off when property prices are rising fast.

Be careful of being sold loan features you don’t need. Offset accounts, for example, are good in theory but require a consistently healthy balance to reduce the interest payments on a loan significantly.

Use lines of credit (which allow unlimited access to funds) with caution - if at all. Only withdraw funds after careful planning. These loans have no regular repayment schedule, so it’s possible to owe the same after 25 years as after one year. It’s like a credit card bill that never gets paid off.

7. THE DANGER OF GETTING FIXATED

Thousands of borrowers fixed at sky-high pre-financial crisis interest rates then missed the benefit from a 4 percentage point drop in standard variable rates after September 2008.

Fixing all or part of a home loan might seem a defence against rising interest rates. The strategy pays off if a rate is locked in and the interest rates drift higher. But borrowers can waste thousands of dollars paying off loans at high fixed rates when variable rates stay well below them – or even fall.

More people than ever before started fixing their home loan rate when the standard variable rate hit 10 per cent.

“It’s the borrower’s psyche,” Cannex financial analyst Mitchell Watson says. “There was conjecture that rates would increase further.”

But they should now think about getting out of the loans and opting for variable rates, as counter-intuitive as that might sound, even if they must pay costly exit fees.

“If you have a high fixed loan, look at getting out of it,” RateCity chief executive Damian Smith says. “It is probably still worth considering switching to a variable rate loan even after the break fees. People will be ahead even within a year.”

Borrowers should consider the amount of interest over and above the standard variable rate they have paid since the start of their loan and compare this to the cost a lender would charge for exiting the loan.

Exit fees (or break fees as they are sometimes known) are the difference between a borrower’s fixed interest rate and the lender’s current fixed rate. It is applied to the number of years remaining on the fixed term and the outstanding balance.

For example, a borrower who fixed for three years at 9 per cent one year ago with a lender whose fixed rate is now 6.6 per cent, would calculate the break fee by deducting 6.6 from 9 and multiply it by two, which makes 4.8 per cent. This is then multiplied by the outstanding balance of the loan, so for a $300,000 loan, the fee to exit early is $14,400, according to RateCity. Other restrictions on fixed loans may stymie your ability to pay off your loan quickly.

“There are limits on how aggressively you can repay a fixed loan given the interest rate is higher than a variable rate,” Smith says.

In its purest form, going on a fixed rate is a hedged bet against an interest rate rise. But just 6 per cent of borrowers are now fixing, which reflects their relative cost versus the price of variable rate loans at present.

Remember, in any bet only one side can win, so you’re effectively betting against the bank. And banks know that rates are on the rise again and have priced their fixed loans accordingly.