# Mortgage Secrets #3 How to Structure Your Mortgages Interest Rate Averaging

So we’re going to talk about interest
rate averaging, and what’s the best way to structure your mortgages so that you’re
not going to get stuck on high rates for a long period of time,
and then you’re also not going to get caught out selecting a one year rate,
and then the next year, the rates just skyrocketed and you’re going to be exposed
to that big change. So a lot of people get confused, should I pick one
year? Should I pick two years? Should I pick a three-year rate?
How should I structure my mortgages? And how do I make sure I’m always
getting the lowest rates? And so, general best practice is called interest
rate averaging. And so what we get is less risk, more reward. And what
we’re trying to do is measure against having some certainty
and accepting there’s going to be a little bit of uncertainty. If I say to you,
“Hey, look, let’s pick a one year rate, let’s go for what, 4.1%.”
And then next year after that expires, it’s up to 6% or 7%, what’s going
to happen is your interest rate expenses are going to almost double.
So that’s not going to be a fun time. And what we’re trying to do is split that
up so that you don’t have that uncertainty of not knowing what the rates
are, and having unexpected costs, but you got the benefit of having the
lower rates for a period of time. And so, this split is called interest rate
averaging. And just the example we’re going to look at today is \$600,000
of lending, and we’re going to put some on 1 year, some on 2-year, and some
on 3-year. And so we’re going to put \$200,000 on each term.
So we’re going to break it down. So this is 2018, 2019, 2020.
And so if you took your \$600,000 and you put all of it on a 3-year, 4.7 rate,
this \$200,000 of lending would be \$9,400 per year for this \$200,000 of lending.
And if you did that for 3 years for the whole \$600,000, so what that means
is if you fixed all of your \$600,000 on a 3-year, 4.7% rate, it’s going to cost
you \$28,200 in interest expense annually. So this is certainty of 3 years on 4.7%.
But you say to me, “Hey, look, I’ve seen this 4.1% rate,
I’d like to take advantage of that.” So what I would say is, “All right,
let’s split your \$600,000 into 3 periods, 3 portions, \$200k on 3 year,
\$200k on 2 year, and \$200k on 4.1% for one year. And so what does that look
like? Well, in 2018, your interest expense is going to be \$9,400 for the \$200k on the
3-year portion, \$8,600 for the 4.3%, 2-year portion of \$200k.
And then that 4.1%, \$200k is \$8,200. And so what does this mean?
Your first year, you’re only going to pay \$26,200. And so,
year, just splitting the mortgage up, you’re going to save \$2,000,
and you can put that money into your principal repayments or go on holiday
or spend it however you want. Now, the certainty of having the three
years does mean it costs you more money. And that uncertainty of picking all
of this one year rate means you don’t know what you’re going to have to be faced
with in year two and year three. And if you wait for all two years,
you wouldn’t know what’s going to be in year three. But the interesting thing
to keep in mind is, let’s say this year one rolls over, and now you’ve got
another \$200k portion and you’ve fixed it for 1 or 2 years, this would have
to be…even if this 1 year rate was 4.7%, then this is going to be \$9,400,
and you add these up, you’re still going to save \$800.
So you can see that even if the one year interest rate spikes quite a bit,
that you’re still going to save money doing interest rate averaging.
And there’s a couple of different benefits. Firstly is,
obviously there’s annual savings and the protection of not being exposed to massive
swings and interest rate changes. But also what it means is, so you’ll
fix this again for another one or two years, and when this one
expires, you’ll fix it for another one year, what happens is,
everything is probably going to come up to be due at the same time after three
years. And it means that you can go and get another cashback if you’re open
to change your bank. So cashback at the moment for \$600,000 might be, you know,
let’s say \$4,500, and by having it all come off at the same time,
that means the break fees are going to be zero. Well, and there might
be a discharge fee or something. But doing the strategy gives you good
flexibility. And what it means is, if we have a look at this graph quickly,
instead of having big swings and writes every three years, and it’s unpredictable,
what we’re trying to do is save money every year by having small portions coming
up, instead of having a big portion fixed for a long period of time.
And making these little, small increments makes it much easier to get
your top ups approved and, like, gives you more, you know, negotiation power,
because it means that list of your mortgage is going to be liable for break
fees, and you get to talk to your mortgage advisor or banker a little bit more often,
which despite the frustrations is actually probably an advantage. So,
hopefully I’ve explained interest rate averaging well. I’ll try
and summarize the points below.