Interest rates are a hot topic right now and for good reason. Since the lowest point in July 2021 when interest rates were around 2%, to the current rates of approximately 6%, rising rates have been hampering investors with the rising cost of interest payments.
Interest rates are always going to be around and unless you're a cash buyer, there is no way of avoiding them but you can reduce your risk.
With the current market, mortgage payments are often outstripping the rental income you receive from a property which means you have a negative cashflow property.
When interest rates are at a lower level, the mortgage payments are lower too and more properties become cashflow positive. The higher the repayments, the worse the cashflow.
Investors can't control the interest rates that banks offer, but they can choose which rate they want to have. What do we mean by this? Well, banks offer multiple types of loans with the main ones being fixed rate & floating facilities.
Fixed rates mean you're locking in the respective interest rate for the prescribed amount of time (e.g. 1 year, 2 years, etc.). Floating rates mean there is no end date to the rate and it floats with the market. Floating rates are generally higher than fixed rates.
But where's the risk?
The risk is that if interest rates go up significantly, so do your costs. If your current repayments are on the limit of what is achievable for you now, any cost increases could be very hurtful to your ability to pay the mortgage.
One way to reduce the risk of sudden cost increases is to split up your loan terms over multiple years and avoid having one large loan. Splitting up your loan terms means you are betting on interest rates moving but you're not fully exposed to one huge increase or decrease.
It's easiest to understand this as a case study. Here's our assumptions:
It's 2021 and the interest rates are at record lows. Main banks are offering 1-year fixed rates at 2%, 2-year fixed at 3%, and 3-year fixed rates at 4%
Investor A & Investor B are looking to lock in their interest rates on their new properties
Both investors have purchased investment properties worth $600,000
Investor A got a mortgage for 80% of the purchase price so their mortgage total for this property is $480,000. They fix this whole amount at 2% for one year
Investor B got a mortgage for 80% of the purchase price so their mortgage total for this property is $480,000. They fixed $200,000 of this at 2% for one year, $200,000 of this at 3% and the remaining $80,000 at 4% fixed for 3-years
Which investor is exposed to the most risk?
In year 1, Investor A pays the least amount of interest. Let's calculate it:
Investor A | 480,000 x 2% = $9,600 annual interest cost
Investor B | (200,000 x 2%) + (200,000 x 3%) + (80,000 x 4%) = $13,200 annual interest cost
So, it seems as though Investor A is in a better position in year 1, but they are still the most exposed to interest rate rises.
If interest rates after 12 months increased across the board by 4%, Investor A will be rocked with much higher repayments at the time of re-fixing their mortgage because his whole loan is re-fixed at the higher rate whereas Investor B only has part of his loan fixed at the higher rate. Thus Investor A at the most risk of defaulting on their loan (all things being equal).
Assuming both investors refixed their loans with the same loan splits but with the new interest rates, let's calculate the difference in payments:
Investor A | 480,000 x 6% = $28,800 annual interest cost
Investor B | (200,000 x 6%) + (200,000 x 3%) + (80,000 x 4%) = $21,200 annual interest cost
As you can see, the interest cost for Investor B is now lower than the interest cost for Investor A. This example is on a small scale, but imagine an investor that is struggling with interest costs, any small increase would affect the ability to repay the loan.
Splitting up term loans allows investors to split their risk across multiple years to avoid having all their eggs in one basket so to speak. The greater the diversity across the loan terms, the more investors split their risk and avoid sudden massive increases in payments.
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