I was chatting to a friend the other day, who is a very smart person, and she sheepishly admitted she didn’t know what her offset account was for. She knew she had one, she just didn’t know why. It is great she has an offset account, as used effectively these can save thousands of dollars per year. This is where we start discussing how to structure our mortgage to make the most out of our financial situation.
How are interest rates set?
Before we start talking about types of mortgages, let’s talk about interest rates. The interest rate is the cost to you of borrowing money and is quoted on an annual basis. If your interest rate is 4.69% p.a. on a mortgage of $281,000 you pay $13,178.90 per year interest (= 281,000 x (4.69/100)). To work out what this is on a monthly basis, simply divide by 12. For this topic let’s exclude repayment of principal in our mortgage payments, this will be discussed in the next post.
Why is the mortgage interest rate 4.69%? A mortgage interest rate is basically comprised of 2 components:
- The cost to your financial provider of borrowing the money in order to lend to you, which is driven by the Reserve Bank of Australia’s overnight cash rate, currently 2.50% (August 2014). The RBA sets this rate on the first Tuesday of every month (except January) based on a number of economic factors to both stimulate and regulate the Australian economy.
This is not exactly what your financial provider pays because it depends on how they borrow the money but if the RBA cash rate is higher, typically it costs more for your financial provider to borrow the money, and vice versa.
The RBA cash rate influences the mortgage interest rate depending on what type of mortgage it is:
- Variable mortgage rates can change on a monthly (and sometimes more frequently) basis, depending on the move in the RBA’s cash rate. Variable mortgage rates typically move in tandem with the RBA’s cash rate.
- Fixed mortgage rates are fixed for a time period, for instance one, three or five years. Your financial provider will forecast over this time period how they think the RBA’s cash rate will move and factor this in. For example, if the cash rate is currently 2.50% and the financial provider expects it to gradually increase to 4.00% over the next three years then they will use an average rate for a three year fixed interest rate.
- The margin your financial provider charges over and above the cost to them of borrowing the money in order to lend to you. Financial providers are businesses with owners and shareholders so they need to make a profit.
Interest is calculated on the mortgage amount on a daily basis, and varies depending on whether you are also paying down your principal or have an offset account.
Fixed vs Variable mortgages
Basically there are two types of mortgages: fixed and variable. A fixed mortgage locks in an interest rate for a period of time. A variable mortgage interest rate moves in line with the RBA’s cash rate.
The pros and cons of a fixed mortgage:
Pro: You know exactly what your mortgage payments are, which makes it easy to budget for and there are no surprises
Pro: If interest rates increase you are protected from this
Con: A fixed mortgage is locked in for the time period you agree up front. So if the interest rates move significantly against you (i.e. mortgage payments decrease), you decide you want to remortgage with someone else, or you sell your property, you are locked in until your mortgage matures. You can break your mortgage before maturity but the fees tend to be huge, effectively the interest your financial provider would have earned from you for the remainder of the mortgage.
The pros and cons of a variable mortgage:
Pro: You can take advantage of downward moves in the interest rate, i.e. mortgage payments decrease
Pro: You are not locked in to a fixed period of time, and can change from a variable to a fixed loan or a different financial provider with no penalties at any time
Pro: typically variable mortgages can have an optional offset account. An offset account is the home owner’s friend – everyone should have one. See below for more details.
Con: Your mortgage payments can change month by month and could increase significantly
Another consideration is if you expect rates to increase, fixing your rate now can have its benefits. It is hard to forecast the movement of rates with any certainty, so I would suggest speaking to a financial adviser. Bear in mind if your financial provider also expects rates to increase, they may have factored this into the fixed rate anyway. If you expect rates to decrease, a variable rate could be beneficial.
Determining the term of your fixed rate mortgage is important. Do you want your payments locked in for one, two, three… years? Some things to consider:
- As above, how you expect rates to move. If you think rates will move quickly downwards you may want to fix for a shorter period of time so that you can take advantage of a lower rate sooner,
- When will you be selling the property? If you plan on selling the property in two years, then fix the mortgage for two years. You will pay significant fees to break a fixed mortgage before it matures, however you may be able to get around this if you buy another property and transfer the mortgage with your financial provider to the new property.
- Are your circumstances going to change: Will you renovate in a year? Will you be moving overseas soon? Are you planning on having children and one parent going on leave? What suits now may not suit in a few years so you may want your mortgage to mature when your circumstances will likely change so that you can re-assess your position and structure your mortgage differently. Maybe hard to forecast but worthwhile considering.
The Offset Account: everyone should have one
Offset accounts are typically available only on variable mortgages.
Cash deposited in your offset account reduces your mortgage payments. If you have a variable mortgage of $100,000 with an offset account and in that offset account you have savings of $20,000 plus your monthly salary of $3,750 is deposited, this “offsets” or reduces the mortgage amount on which you pay interest:
Mortgage amount $100,000
Less: Savings $ 20,000
Less: Monthly salary $ 3,750 (deposited on 1st of each month and drawn upon to pay bills and expenses for the month)
Net mortgage amount $ 76,250
Monthly mortgage payment on $100,000 at 4.69% = $390.83
Monthly mortgage payment on $76,250 at 4.69% = from $298.01 (depending on when bills/expenses are paid and money is withdrawn)
Saving of $92.82 per month or $1,113.84 per year.
Any cash you deposit in your offset during the month will save you money. The more you deposit the better!
The offset account amount is equal to the variable mortgage amount. In determining how big your variable mortgage should be I think considering how much you can put in your offset account is important. If you have savings of $20,000 and you plan to save more, you might want to make your variable loan (and therefore the offset account size) at least $20,000.
Make sure you get a drawdown facility on your offset account so any funds deposited can be withdrawn if required.
You can have it all: fixed AND variable
There is no right or wrong answer whether you choose a fixed or variable mortgage; there are benefits and negatives to both. What is important to know is that you are not confined to only one type – you can split your mortgage between both fixed and variable. So when you buy your $380,000 property and take on a $281,000 mortgage you could make half fixed and half variable, or any split of your choice.
In addition you can change some or all of your variable mortgage to fixed at any time and when your fixed mortgage matures you can change some or all to variable.
Each financial provider will have different fixed and variable mortgage products with different features so speak to your financial provider or mortgage broker for more details. Speak to your financial adviser to determine the best split between fixed and variable for your circumstances.
Propertyosophy 