The final big question: To Fix or Not to Fix your Interest Rate?
You have come to the right place, I have the answer for you!
It is often asked whether to have a fixed or variable interest rate on your investment loans. Before you make a decision like that you need to ask yourself another question:
Are you smarter than the banks?
If you believe you are smarter than the banks, first of all, make sure you don’t suffer from A&I Disease (Arrogance & Ignorance Disease – a cruel and crippling disease that costs many investors hundreds of thousands of dollars every year!).
Remember this, the banks employ hundreds of highly educated people to keep an eye on the economy and try and predict what will happen to the Reserve Bank’s base interest rate.
You see, to put it in very simple terms, the banks borrow money from the Reserve Bank at the base rate and then lend it to you and others at a slightly higher rate. The difference between the two rates is how they make their money.
Have you ever noticed that the fixed interest rate is usually higher than the variable rate? The reason for that is that if the bank is going to let you have a fixed rate, they need to cover themselves for the eventuality that the base rate may go up on them while you have a fixed rate. So they need to build in a margin for that so they can still make some money. That’s why they usually make the fixed rate a little bit higher than the variable rate.
On the odd occasion, you may see the variable rate higher than the fixed rate. What that actually tells you is that the banks think that the base interest rate is actually going to come down. So naturally, they want to encourage you to lock in at a rate that they expect to end up higher than the level they expect the variable rate to drop down to.
So as a rule of thumb, if the fixed rate is higher than the variable rate, the banks think rates are going up. If the fixed rate is lower than the variable rate, the banks believe interest rates are coming down. The bottom line is if you think you’re smarter than the banks, go ahead and fix your rate. Otherwise, leave it on variable and put the rest of your money into your buffer.
Now you may be thinking ‘But what if rates go up too much? I can’t afford to pay more, so I will just do it for the security’. Well here’s another strategy. Get an offset account and put your extra cash in there instead.
An offset account is a bank account just like any other account. It has an account number and BSB number, but it works differently. It is connected to an associated mortgage account. When it comes time to charge interest against the loan account, they subtract the amount in the offset account from the amount owing on the loan and only charge interest against the balance.
For example, if you have a loan for $100,000 and an associated offset account with $10,000 cash in it, you will only be charged interest on $90,000 of your loan.
So if you can afford to pay more, why would you? Just pay the minimum required and put the rest into an offset account. The effect is the same, you are still reducing the interest on the loan, but you will very quickly create a large cash buffer to act as a safety net. If rates go up, then you can use the cash buffer to absorb that. But what if they don’t go up? Which is what happens most of the time. Then you get to keep your money in a place where you can get it readily in an emergency.
So in summary, we normally don’t fix our rates. The banks are smarter than us when it comes to that. We just get an offset account and pay all income directly to it, and then let the interest for the loan come out of there.
We know of some investors who have an interest-only loan with an attached offset account that has the same amount of cash in it as the loans they are against.
Why not just pay out the loan, you ask? Well, what’s better, being debt free and having no cash, which is what you would be if you paid the loan out with the cash, or paying no interest and having a massive cash buffer available for an emergency or another investment opportunity that may pop up? If you said the latter, you’re starting to think like a successful investor!
I hope you have enjoyed this series.
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