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I was reading an article last week about folks who have fixed their mortgage interest rates AND suffered the consequences.  It reminded me just how significant, perplexing and urgent a decision it is. . . to fix OR not to fix.

Before I launch into a discussion about this extremely important topic, I issue one caveat:  almost everyone has an opinion and what follows is my opinion based on personal experiences – my own AND those of my clients. Ultimately you will need to make your own decision. You should seek the advice of your professional advisors prior to making your decision.

Notwithstanding this discussion is based around personal opinion, there is a good deal of anecdotal evidence to support my proposition.

OK, now that’s out of the way, let me answer the question: ‘should you consider fixing your mortgage interest rate or not?’

My definitive response to that question is NO!  Let me explain why.  I call this. . .

‘5 Reasons Not To Fix Interest Rates’ –

Reason #1: How do you know where the cycle is at?

Like most elements of the economic equation, interest rates run in cycles – they go up and they go down.  In fact when you graph interest rates over time, they appear like a ‘bell-shaped’ curve with ‘peaks’ and ‘troughs’.

If the standard variable interest rate is currently at (say) 5.6%, are rates at a peak, a trough OR somewhere in between?  In my experience, in order to get it right, you either (i) need to be brilliant (having completed your calculations, graphs, etc and come up with the right outcomes in terms of where the interest rate cycle is at) OR (ii) need to have ‘lady luck’ (in copious quantities) on your side.  Well let me tell you, neither occurs very often so probability is definitely on the lender’s side.

Reason #2: How do you know what’s likely to occur in the future?

If you are able to predict the future, please give me a call – I have a business proposition for you.

If you have had any experience investing in or trading the share market, commentators often talk about the difference between predicting the future and the probability of something occurring in the future.  It is impossible to predict the future . . . at best we can only attempt to calculate the likelihood (probability) that something will occur.  I don’t know about you BUT I have little confidence when attempting to ‘guesstimate’ where rates are likely to end up.  Anyway, generally speaking, fixed interest rates tend to factor in rate increases well in advance, so by the time you decide to fix, it’s probably too late anyway.

Reason #3: Do you really want your banker to control what you do?

Imagine you want to buy your first (or another) investment property and your existing lender (with whom you have a fixed interest rate loan), will not ‘come to the party’ with the necessary funds.  You decide to change lenders – to one that will lend you the money required.  You approach your current lender for a payout figure on your existing (fixed interest) loan and are informed that in addition to paying back the mortgage balance, you are up for break costs of an additional (say) $30,000 (I’ve used $30,000 only as an example based on recent anecdotal evidence – break costs will vary based on the circumstances of each individual loan BUT they usually are significant).

You now have a decision to make. . . break the loan and incur the significant costs OR not.  If you decide not to break the loan, there is a strong possibility you may not be able to buy that investment property.  In other words, your lender is in control.

Reason #4: How much will it cost you in ‘break costs’?

A common response to this question is. . . ‘BUT I wont need to get out of the mortgage contract and therefore I wont be affected’. I cannot calculate the number of folks who have said this to me only to find that some time during the fixed rate period, they either want to OR need to exit the fixed rate loan contract.

Most folks seem to think that circumstances will never change and that even if they would prefer to exit the contract, they will hang on to the end (and therefore not incur break costs).  What they fail to consider is that individual circumstances do change – could be employment, health, family or a variety of other reasons.  In other words, based on changing circumstances, you may not have a choice.

Reason #5: How much will it cost you in the mean time?

With most folks there is usually a ‘time-gap’ between the level variable rates are at AND when they make a decision to fix.  An example will help to demonstrate:

Imagine the standard variable mortgage interest rate is currently 5.6% while a comparable (in terms of features) 5 year fixed rate loan is 7.5%.  That means your variable interest rate will need to increase by almost 2.0% (7.5% – 5.6%) before you start gaining any benefit.  At this point you need to ask yourself two questions: (i) are interest rates likely to increase by 2.0%+ over the next 5 years? AND (ii) even if they do (increase by 2.0%+), when will they increase?  Normally rates increase gradually, so if you were to fix your rate at 7.5% right now, you will have to wait until variable rates increase by more than 2.0% before it stops costing you money.

Well there you have it.  In my opinion, no-one should ever fix interest rates because the balance of probabilities (the likelihood of guessing right) is definitely in the lender’s favour.  I don’t know about you BUT the one thing that really ‘urks’ me is lenders having more control over my investments than me.  After all, isn’t the purpose of education and experience to control your own destiny. . . no-one cares more about your money than you.

Want to learn more about Real Estate Buyers Agents and how to develop amazing property strategies?

Claim Garry’s popular Free Report: “The 7 Most Costly Mistakes That Property Investors Make And How To Avoid Them” identifying strategies you can implement immediately guaranteed to save you thousands, available at:

http://www.ifyl.com.au

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Common sense says that the less cash you need to fund your investment the better off you are.  As a rule of thumb, property in a city location – particularly inner suburbs – offers considerably lower yields than property in country and regional areas. There’s usually a trade-off between yield and capital return: city investment prices have tended to outstrip non-urban prices in terms of capital appreciation; therefore an inner-city apartment might have a low yield (due to the high purchase price) but demonstrate strong capital growth (historically), whilst country properties might return a high rental yield but demonstrate lower capital growth.

The truth is that positive cash flow property is a bit like the Tasmanian tiger: they exist but finding them is another question. You can find them but you’ll generally only find them in suburbs or towns which present the investor with changing questions: “Do I really want to invest here?”  We are not taking an overly negative view of such opportunities but do suggest investment on cash flow grounds need consideration of certain criteria:

1. A regional or rural town must have a population base of at least 2,000 dwellings
2. Real estate should indicate a future growth rate of better than five per cent, and
3. A property should show a gross rental yield of better than five per cent.

Tax matters

A high marginal rate tax payer derives significant benefit from receiving marginal tax cuts while (depending on the timing of any  sale), paying tax on only 50 per cent of the capital profits generated.

A low growth/high yield strategy is likely to suit those on lower incomes as the extra rent may allow them to fund an additional property. The lower income earner has fewer dollars available for funding their investments. Indeed some lower income earners who aspire to be property investors simply cannot afford to fund a negative cash flow.

Positive cash flow investing means that you have more money coming in from a rental property than is going out. It is the cash left over after allowing for cash costs of mortgage, insurance, interest, maintenance expenses, and supplemented by the non cash tax deductions (deprecation etc). If the operating expenses exceed annual income, the tax break becomes tax back in your pocket. When the after tax effects are added in to the investment equation and a positive result is achieved then you have positive cash flow from a property investment:

Positive cash flow investing remains vastly misunderstood by many investors.

Whether an investor finds a property that generates a positive cash flow depends on many things: rental income, the interest rate, allowable deductions, and your own marginal tax rate. As a simple rule of thumb threshold gross rental yield of around 8 per cent is needed to achieve positive cash flow, however (as mentioned above), this depends on the numbers involved with each specific property.

This should not be taken as a magic number, rather as just one of a number of selection criteria. The other issue is that of real long-term capital growth. This may mean eschewing fashionable urban areas in favour of drab, industrial suburbs or, as discussed earlier, regional or country towns.

A word of warning: if you are focusing on positive cash flow investments and considering investing in regional or country areas (for example), you MUST develop an intimate understand and knowledge of the issues involved and how best to proceed otherwise it could cost you BIG TIME.

Yield investors need to have their calculator ready to ‘do the numbers’. This involves making an estimate of the potential income (remembering to build in a vacancy factor of say, 2-4 weeks a year and the costs associated with advertising the vacancy), then adding up all the costs, including potential repairs. The remaining figure will be the amount of cash flow. Tax deductions in relation to depreciation on buildings, fixtures and certain contents will boost yields further as these are non-cash, tax deductible expenses in the year they are applied.

Risks

A regional or rural investor attracted by high rental yields must be concerned about the local economy. Investors feeling warm and fuzzy about high regional yields need look closely at the local economy.

Investors in regional towns are faced with higher risk than their city counterparts. In some towns you have to wonder whether there will be any population growth at all. If there isn’t going to be any real economic growth in a town then investors need to be compensated with a much higher rental yield.  Intending investors need to conduct a risk review that considers local economy risk as well as the more general risk of interest rate rises.

Leading into 2010 (and beyond), never has it been more important that investors understand what they are doing.  This market is not the time to be taking unneccessary risks.

Want to learn more about Real Estate Buyers Agents and how to develop amazing property strategies?

Claim Garry’s popular Free Report: ‘The 7 Most Costly Mistakes That Property Investors Make And How To Avoid Them’ identifying strategies you can implement immediately guaranteed to save you thousands, available at:

http://www.ifyl.com.au

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