Understand the fixed and floating rate selection along with the impact of payment terms and tranches for your mortgage.

This is the second post on our home purchase, with this topic being on the selection of mortgage rates, and specifically the choice of fixed and floating, loan term, and payments term.

As one first point, the term of interest rates, and payments term are usually locked in once the house purchase has been made, but before signing contracts. However, you should have some idea about what rate structure and payments term you will select prior to this point so you will have a good understanding of the likely cost of financing. This will hopefully avoid any late surprises especially during times like the present where rate movements have been quite significant.  

• To fix or float – The main considerations here are whether you prefer payment certainty, in which case you would go for fixed, or if you would like flexibility to repay early or refinance – possibly if you have a view that mortgage rates may decrease soon. The other alternative is that you can go for a mix of fixed and floating to provide some ability to make pre-payments (against the floating tranche), whilst still having some payment certainty against the fixed tranche.

• Loan Term – We chose to have multiple tranches with an offset account (to allow pre-payments), along with two-, three-, four- and five-year fixed tranches. The shorter-term fixed tranches of two and three years were structured to allow us to save money to make a large repayment when they come due (30% of the total mortgage split across these trances), whilst the longer-term tranches of four and five years (60% total split across these tranches) will be refinanced at a much smaller amount by the time they are due for refinance.

We have also allocated a small amount to an offset account (10%) which will also allow the opportunity to make additional pre-payments whilst also reducing the interest cost by way of the offset (credit balances held in our savings account will offset the interest-bearing principal on the offset loan balance).  

When selecting these tranches, our first consideration was achieving a balanced refinancing structure to allow us to make more repayments if needed and potentially pay off a larger tranche when it matures, whilst the second was seeking to provide some balance to the interest rate exposures. At this point I believe that higher rates will be slow to move down, and mortgage rates may even continue to increase. As such, I saw more risk to the upside so locking in rates for a period was the preferred approach.  

• Term of payments – Whilst the loan term may be for up to five years, you can choose your payment terms to be longer which will impact the amount of the loan balance that you pay with each payment. Some may choose up to 30 years, whilst others could look at a shorter term of say 20 years. We chose to have a 20-year repayment period to balance the amount were comfortable with paying based on our current budget.

It is good to note that you can adjust this payment term to either speed up or slow down the payment depending on your financial situation at any point in time.

For many people over the past several years, the view on rates was that they would be “lower for longer” and that low rates are the “new normal”. These were not just the views from individuals, but from high profile economists, and financial commentators.

These financial commentators have since been proven quite wrong, and this is the main reason that I will look to take an approach which works well for our family to avoid all the noise and regret. Key for our family was the certainty of payments so that we can budget effectively and build flexibility into our payments structure if required.

As always, preparation is key, so understanding your parameters leading into a house purchase and the likely repayments will reduce the change of surprises and regrets.