The 3-Step Loan Formula That Beats Rising Interest Rates

July 27, 2022
The 3-Step Loan Formula That Beats Rising Interest Rates

It’s a hot topic: with interest rates on the up, should you fix your home loan at the current rate, or stay on a variable loan with crossed fingers?

Rather than leaving it up to chance, get ahead of the game with a combination of loan types that not only helps counterbalance rate rises, but also pays your loan down faster.

Here’s how the magic works in three steps.

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A combination loan offers pay-down power

Rather than fix your entire loan (which has its pros and cons), you can combine a fixed and variable loan to provide flexibility, the power to reduce your interest, and some protection from rising interest rates.

If that sounds too good to be true, have a look at how the fixed-variable-offset loan combination looks:

  1. You fix a portion of your loan (to protect against rate rises).
  2. You keep the rest variable (in case rates fall).
  3. You add an offset account (plus add-ons) to reduce the interest payable.

Let’s look at each step.

1.  You fix a portion of your loan

The 3-Step Loan Formula That Beats Rising Interest Rates

When you take out a loan or refinance, you’ll likely have the option of locking in an interest rate for a set number of years (typically between one and five).

Called fixing, this strategy offers protection against interest rate rises and higher repayments during the fixed period.

The downside is that fixed loans charge a higher interest rate because banks factor in future rate rises. That means you’ll pay more interest on your loan initially. It’s a downside, but you’re sitting pretty if rates go up.

By fixing only a portion of your home loan as part of your combination strategy, you’re both protecting part of your mortgage from rate rises and keeping repayments down by not locking in the full amount at a higher fixed rate.

2.  Keep the rest of your loan variable

The 3-Step Loan Formula That Beats Rising Interest Rates

Choosing a variable home loan means your interest rate will rise and fall according to the cash rate set by the Reserve Bank of Australia. Interest rates have been rising since 2020’s record low of 0.01%, but that doesn’t mean a variable loan is a poor choice.

When combined with a fixed portion of your loan, a variable loan gives you flexibility. If rates fall, the repayments on your variable portion will fall too, and you can reassess your combination-loan strategy once the fixed term is finished.

You can also add an offset account to the variable portion, which is the third element in paying down your mortgage faster. You can’t use an offset account with a fixed loan.

3.  Add an offset account

An offset account allows you to ‘park’ your cash in a savings account that acts as a payment against your mortgage. For instance, if your mortgage was $750,000 and you had $50,000 in your offset account, you’d only pay interest on $700,000.

Reducing your interest component pays your loan down faster; in fact, it’s possible to reach a point where your savings equals your remaining mortgage, and you pay no interest at all (the ultimate defence against rate rises!).

Using our example above, if you had $50,000 in your offset account and didn’t add a single dollar to that amount for the length of your loan, you’d save $104,000 in interest and take 2.5 years off your 30 year term.

Adding in extra tools can help you maximise your offset funds and reduce your interest further. A credit card is one handy tool you can use.

For extra oomph, use a credit card…wisely

The 3-Step Loan Formula That Beats Rising Interest Rates

To make the most of your offset account, you can use a credit card with interest-free days to pay for your everyday expenses so you have more money in the bank each month offsetting your interest.

For instance, let’s say you had $50,000 in your offset account. You earn $1000 per week. By using your credit card for everyday spending, by the end of each month you’ll have an extra $4,000 in your offset account. Then, you pay your credit card balance back in full and start again for the next month.

Over time, those extra offset funds can take years off your loan.

Caution: always look for a credit card that offers interest-free days, and pay it off in full each month. You can also look for cards with no annual fee. Otherwise, you risk undoing any long-term savings by paying interest or high fees on your credit card.

How to know if it’s right for you

One of your priorities as a homeowner is to make sure you can manage the repayments comfortably. Whether a combination loan is a good fit will depend on your financial situation and your loan amount.

A mortgage broker will be able to calculate a combination loan to see what proportions save you the most money, and if it’s suitable for you. Mortgage brokers are generally free, and know which lenders offer offset accounts, home loan packages, and new customer deals.

Pauline Hatch
Pauline Hatch is a personal finance expert at Creditcard.com.au with 8 years of personal finance under her belt. She loves turning complex money concepts into simple, practical actions that help people succeed financially. Pauline believes everyone can win with their money if everyone can find out how (for free, of course).
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