How to beat the interest rate hikes

This time next year the cash rate could be as high as 5 percent, meaning this month's rate rise of 0.25 percent is just the beginning of an upward rate cycle.

One-quarter of a percentage point may not be too painful – around $45 extra each month on a $300,000 6 percent variable mortgage – but if the RBA continues to tighten the screws, November 2010 could see the average homeowner pay a further $236 a month in repayments.

So, what’s a homeowner to do?
This was the most-asked question at this year’s Home Buyer Expo in Melbourne. On the one side you’ve got new homebuyers worried about whether or not they should lock in – after all, rates are on the rise!

Then there’s the good chunk of homeowners who locked in for three years at 9% between March and October last year.

Just quietly, I think they may be rejoicing about the latest rate hike because it’s got to hurt when you lock in for three years only to miss the benefit of a 4.25%-point drop in standard variable rates.

Still, according to ratecity.com.au, now is the time for those homeowners to pay the thousands of dollars needed to get out of their fixed loan and still come out ahead.

How so? Well, put simply, because fixed rates have been rising and variable rates have stayed low, break fees to cancel fixed home loans are the lowest they’ve been in almost a year.

Break costs are calculated by the amount of interest the lender will lose from terminating the contract before the fixed period is finished. Ratecity calculates the break fee for a $300,000 loan balance to be $14,400.

By switching to a lower variable rate it calculated you would save around $10,000 in the first year.

This means in the second year on the variable rate you’d recoup the rest of the $4000-odd in break fees and then you’d be ready to reap the savings of switching. This of course rests on the assumption that variable rates don’t move up too hard or fast.

For homeowners who didn’t lock in there are lessons to be learned from your fixed peers. Interest rates can rise as fast as they fall. So what strategies do you put in place to cushion rate movements?

The decision is ultimately yours but, given the average standard variable rate charged by the four majors is 5.96% as opposed to the average three-year rate sitting at 7.19%, it would make more sense to stick with variable.

Hedging your bets by splitting your loan into fixed and variable portions is not a bad idea. Either way, if you lock in now you’d be paying a premium of around $200 extra a month.

According to research by ratecity.com.au, even if rates go up 1.3% in the next 12 months, you’d still be better off over a three-year period sticking with a variable rate rather than the current benchmark three-year fixed rate. If you’re concerned about rate rises, here are five ways you can cushion the blow:

Pay as if you are fixed
By paying more you reduce your loan faster, creating a buffer for when rates do rise. Most homeowners have not reduced their repayments in line with when rates were slashed, so there’s plenty of room for movement for them.

Don’t pay the standard rate
Packaged home loans, online home loans, no-frills loans, reward home loans and the latest capped home loans can all offer great discounts off what the standard variable rate is. Check www.ratecity.com.au or www.infochoice.com.au for the latest deals. Just watch out for the traps of refinancing.

Pay a little more
Paying a little extra every month can have a big impact in the long run. Just $10 extra a month can save over $3600 in interest on a $300,000 mortgage. Pay $50 more a month and change your repayments to fortnightly and you’d save over $60,000 in interest.

Offset
If rates rise investors will get more bang for the dollar, but investors with a home loan would be better off stashing their cash in an offset account. Loan accounts such as a 100% offset account enable consumers to link a savings account with their home loan account, and “offset” or use that amount to reduce the interest accumulated on their mortgage. Not only do you save on the interest and term, you don’t pay tax on the interest earned in the offset account.

Consolidate your debts
You can reduce your monthly fixed commitments by rolling your credit card debt, car loan or personal loan into your home loan. The extra cash should go straight back into your loan so that you don’t end up paying more interest in the long run.

Money Magazine's November 2009 issue is out now. Subscribe now.