Thursday 7 November 2013

Friday's Five Minute Finance: You've got to know when to hold them...

... know when to fold them, know when to walk away, and know when to run.

So said Kenny Rogers in The Gambler, talking about poker. And, pretty much, the same can be said for one of the most critical aspects underpinning any house renovation or purchase, and that is what decision to make on managing interest rates. Or more specifically, whether to fix  your loan, or leave it on a variable rate. I said this weeks finance piece would be more renovation/home orientated, and with interest rates so low in Australia now, I thought it would be good to prompt people to seriously consider whether the time is ripe to fix your rate and lock it in for a set period of 1 to 5 years.
Even though market commentary is still emphasising the likelihood of one more interest rate cut before the cycle bottoms, and interest rates eventually start marching upwards again, if you were a pragmatic individual you would probably consider that for the Australian market we are at the bottom of the cycle. In fact the bottom of the cycle was probably six months ago, and if you are making the decision as to whether to fix your rate or not, you should probably approach the equation like a blackjack player would when betting against the house. Remember that Casino's don't get to be big and rich by failing to understand the odds and letting the gamblers win, just like Banks don't get to be big and rich by failing to understand market movements in interest rates and letting mortgage owners get a better deal than the banks. The reason you like compounding interest and its effect is the same reason the banks do...

So what if you are about to start a renovation and have a sizeable loan that is going to add to your mortgage? Or you have just bought the house of your dreams and are the proud owner of a sizeable mortgage? Or what if you are halfway through paying off your mortgage? What can you do to ease the burden on interest payments and improve your odds against the house (aka the bank in this case)? My suggestion is regardless of which situation you find yourself in, get yourself into a regular habit of reviewing your home loan on an annual basis, and look for options that reduce the amount of interest you might pay. Here are a few suggestions:
  • If you are thinking of going for a fixed loan, consider the benefits of locking in a rate for the next few years. Do you think that interest rates on offer from the banks will still be hovering around 5% in 5 years from now?
  • If you are unsure and want to hedge your bet, you could consider splitting your loan and locking in half of the loan at a fixed rate, and half at a variable rate.
  • Look beyond your current loan provider, and see what deals are on offer; there is no brand loyalty with banks - what counts is that you get the best deal.
  • Once you see what options are available, go into your bank and ask them to match the rate on offer elsewhere. Do you think they really want to see you walk out the door with such a sizeable liability that still has 15 - 20 years left to run? *cough* "Computer says no..."
  • Consider setting up an offset account linked to your home loan - for example if you want to keep an amount of cash set aside for emergencies (say 2-3 months salary), placing that in an offset account will reduce your interest payments as the interest will be calculated on the balance of the loan minus the amount in the offset account. eg: $200k loan with $20k in the offset account means interest is only calculated on $180k of the balance.
  • If you need to free up some cash flow for a set period, and you are ahead in repayments, you might have the option to reduce the amount of principal and interest to the minimum, or switch the loan to interest only for a period of time (eg: 12 months).
  • Pay the loan off quicker by making lump sum principal payments annually where allowed. Use any of the major banks online calculators to see how much this will reduce the amount you pay in interest that is non-deductible and could be put to better use elsewhere.
If you decide to do any or all of the above, make sure you research widely, seek a second opinion, and read the fine print in the financial services guide and the product disclosure document. The devil, as they say, is in the detail. Watch out for hidden fees, penalties if you switch then switch again, penalties for early payout of the loan, and/or any other hidden costs. And go into the bank and speak to a loans officer, or if you want a second opinion speak to a mortgage broker (but be aware they make their money on commission - which they will disclose to you). Unless you work in finance, resist the temptation to do this all on line, whereby you will assume the risk completely in making the decision and potentially getting it wrong.
But there is no time like the present to check out your finances in relation to your home loan or renovation loan, after all, what's better... $20,000 in interest in the bank's next billion dollar quarterly profit announcement, or being able to afford that new $20,000 dream kitchen you've always wanted? Because we can't all be like Clarke W Griswold and rely on that Christmas bonus or winnings at the Casino for the new pool / kitchen / house extension.

Go you good thing !!
Cheers, Col

Disclaimer: This advice is general advice only and does not take into account your individual financial situation and circumstances. You should seek independant financial advice prior to making any investment or financial decisions yourself.

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