Interest Rates - what's best for Property Investors

As a property investor you may want to know what type of mortgage is best for you, a variable interest rate loan or a fixed interest rate loan. Read on to learn the differences, risks and benefits of each.

What is a Variable Interest Rate Loan?

A variable Interest Rate Loan is a loan where the interest rate may be varied at the Lenders or Banks discretion.

Over the term of the loan the rate may fluctuate substantially, the rate may rise or fall usually dependant on economic conditions at the time and usually following to a large degree the “cash rate” set by the RBA (Reserve Bank of Australia).

For property investors a variable rate loan is usually the most appropriate as it will follow the economic conditions and so when rents are high and there is more money around the rate will usually be higher to soften inflation; when times are tough and rents are lower due to lesser demand from tenants, the rates will soften and drop.

There are no limits to the amount of interest for which you may be liable. If interest rates change your repayment amount may need to be adjusted to suit these changes.

What is a Fixed Interest Rate Loan?

A Fixed Interest Rate Loan is a loan where the interest rate is set and stays the same for the agreed period of the loan. This is usually only good for Investors if they can lock it in at the bottom of the market at a minimum rate and protect themselves from the rise.

The fixed Interest period may be shorter than the total loan term and in this instance the loan usually reverts to the lenders variable rate once the fixed term has expired. The question here is how do we know when we have hit the bottom of the market?

Is a Variable or Fixed Interest Loan best?

The answer to this question will depend on your individual circumstances and the level of risk you are prepared to expose yourself to. There are risks involved in both.

Factors you should consider include:

Predicting future Interest Rate fluctuations
It is very difficult to forecast long-term future interest rates accurately. There are various sources of information in the media which may help you estimate whether rates will rise or fall in the immediate future and these sources will help you decide whether to fix rates or have them as variable.

Falling Interest Rates
If Interest rates are about to fall it would generally be wise to have a variable rate loan. I have seen some property investors lock rates in for up to 5 years as rates are shooting up only to commit themselves to a high rate for years to come as variable rates drop costing them up to $100s of thousands of dollars in extra interest payments.

Rising Interest Rates
When Interest rates rise it is generally a good time to fix your rate in to protect yourself from future rises. Be careful though, you can still be caught. I have a client who fixed in when rates were rising. Unfortunately as they fixed in, rates reached their peak and then began to fall eventually dropping a further 4%; this meant to break the fixed rate they had to pay around $80,000 as they fixed for 5 years. The longer they waited the higher the break cost was, this was due to interest rates getting lower and lower over time.

It is always wise to discuss what path to take with an Accountant prior to making a commitment either way.

What are the advantages of Fixed Rate borrowing?

The main advantage to fixing your rate for a period is that you know exactly what your payments will be each month for that period; this allows you to budget accurately. You will also be protected against unforeseen rate rises which could put financial pressure on you; the trick in all of this is to fix when wholesale rates are at their lowest.

A fixed rate loan is like an insurance policy where you pay a certain pre determined amount to know you wont be affected by any variations in Interest rates.

What are the main disadvantages of Fixed Interest Rate Borrowing?

The main disadvantage is not if wholesale and variable rates fall, but if they fall and you are in a position where you have to payout your loan early in the case of a property sale or separation. The reason this is so bad is that you will be subject to break costs and Bank fees and charges which may be substantial.

Calculate Your Break Cost

To calculate your break cost the following formula will give you a guide only, you will need to contact your Bank or Lending Institution for an exact amount.

W*B*#m*N= Break Cost

Where:
W = the difference in the original wholesale interest rates at the time of establishing the fixed rate loan minus the wholesale interest rate at the time of paying out the loan divided by 100.
B = the balance due on the loan
#m = the number of months left before the fixed term expires divided by 12
N = the Net present value discount factor i.e. the outstanding balance minus the maximum pre-payment amount divided by the outstanding balance.

An example follows

I have a fixed rate Interest only loan where the balance owing is $480,000 fixed on a 5 year term where 18 months have passed since I took out the loan.

When I took out the loan in August 2007 the wholesale rate was 7.48%, the wholesale rate in February 2009 is 3.48%. I am allowed to pay off $15,000 without a penalty.

My Break Cost would be approximately:
.04 times 480000 times 42 divided by 12 then multiplied by 465000/480000

Which equals $65,100 - yes thats correct.

The saying goes "You lock interest in Bank always win" this is because the Bank merely sells you the money on a fixed rate loan at a margin above what the cost of the money to them is and then charge you accordingly if you want to pay out early and the cost of funds has dropped.

The big benefit to the bank is that if the cost of funds rises they will not charge a break cost but will resell the money at the higher rate and keep 100% of the profit.

Break Cost Calculator

For this formula to be accurate it is imperative that you know what the swap rate was for the specified period of the loan at the time of setting the loan.

Break cost calculated will be an approximate only due to all Lenders having variables in the way they calculate the "Break Cost"; to come to the exact amount you must contact your Lender directly.

The figure arrived at is to be used as a guide only and must not be relied upon to calculate your final figure which may change daily

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