Which interest rate should I choose?

Interest rates are high. So, a lot of investors ask: “How long should I fix my mortgage interest rate for?”

The thing is, no-one knows where rates will go month-to-month, year-to-year.

Sure, experts provide forecasts, but we can’t predict the future.

Things happen, and interest rates change. Two years ago it was Covid (no-one saw that coming), then inflation … something will be next.

So, in an uncertain environment what’s better – the 1, 2, 3 or even the 5-year fixed interest rate?

In this article, you’ll learn 3 strategies you can use to find the right interest rate for you.

How do I choose my rate?

First, what are you trying to do when choosing a mortgage interest rate.

Usually, it’s not about getting the lowest rate today. It’s about getting the lowest average rate for the next 5 years, because that’s the longest you can lock your interest rate in for.

Right now, the 5-year rate is cheaper than the 1-year rate.

But if interest rates go down, today’s 5-year rate could look expensive in a few years.

Here are the strategies you can use.

Strategy #1 – Blindly lock in the 1-year interest rate every year

One option is to choose the 1-year interest rate every year. No matter what.

Over the last 20 years that would have given you the lowest rate on average.

Let’s say you fixed for 1 year every year for the last 20 years.

Sure, sometimes you’ll pay a higher interest rate.

Locking in for 5 years back in 2004 would have given you a lower rate between 2006 and 2008.

That’s because the 1-year rate jumped from 6.9 to 9.7% in just 4 years.

But then the 1-year rate went down quickly. So, over time the 1-year rate has been cheaper than the 5-year rate. So, this strategy works for investors who say, “I don’t know where interest rates will go. Locking in for 1-year has been a good strategy in the past. I’m going to do that today.”

You won’t always come out ahead, but over time you likely will.

Let’s say you had a $500k mortgage (on P+I) back in 2004. If you locked in the 1-year rate every single time, you would have saved:

• $30k, compared with being locked into the 2-year rate every single time.
• $39k, compared with 3-year rate every single time.
• $95k compared with 5-year rate every single time.

Big savings.

Strategy #2 – Split up your mortgage

If you don’t want to put all your eggs (or mortgage) in the same fixed-rate basket – you can split it up.

Let’s say you’ve got a $500k mortgage.

Some investors will put $250k on 1-year fixed. They’ll fix another $250k on a different term (e.g. 2-year or 5-year).

If you do this, you’ll get an average of the market over time.

That does mean you’ll never get the absolute lowest interest rate, but if you choose the “wrong” interest rate, then you’re only half wrong.

So this strategy works for investors who say, “I don’t know where interest rates will go. Let me hedge my bets.”

An investor I recently worked with fixed half their mortgage for the 5-year fixed when it was 2.99%. They fixed the rest for 1-year. They’re now paying over 7% on one part of their mortgage, but are still paying under 3% for the other part.

They’re happy. Their interest rate is about 5% (on average). They’re stoked. It’s a win for them.

More from Opes Partners:

• How to handle higher interest rates... 4 strategies to manage your cashflow (Podcast)
• What are the current interest rates in NZ? (Article)
• The latest interest rate changes from the main banks (Article)
• Current interest rate predictions (Article)

Strategy #3 – Run the numbers (advanced)

Right now, the 5-year rate is the cheapest on the market. The lowest advertised 5-year rate is 6.39% from Westpac.

The lowest 1-year advertised rate is 7.15% from Kiwibank.

So when would it make sense to take the 1-year over the 5-year?

And how far would interest rates need to fall for it to be worth taking the higher rate?

Here are the numbers:

You’d need to get an average rate under 6.20% over the following 4 years for the 1-year rate to be worth it.

So ask yourself: “Once my first year is up, could I get an average interest rate of less than 6.20% (on average) for the next 4 years?”

If you think the answer is “yes”, go for the 1-year.

If you think the answer is “no”, take the 5-year.

The purpose isn’t to guess the interest rate precisely. It’s about giving you a frame of reference so you can decide which rate to choose.

You can download the spreadsheet I showed above here.

What strategy is the right fit for me?

The right strategy for you will hinge on these 3 things:

#1 What you think will happen with interest rates

As a rule of thumb:

• If you think interest rates will go up, lock in for longer.
• If you think interest rates will go down, lock in a shorter term.

It’s not necessarily about choosing the lowest rate today. It’s about what’s going to give us the lowest average interest rate over the next couple of years.

Today, if we chose the lowest interest rate you’d go for the 5-year interest rate.

But you might not want to be fixing for 5 years because rates are high. What if interest rates go down soon?

In 2021, interest rates were low. So, locking in the 5-year interest rate was the smartest thing to do.

At the time, that rate was 2.99%. No, it wasn’t the best interest rate, but it was fantastic looking back.

#2 How much you can handle interest rates changing

You've also got to ask yourself if you’re OK with uncertainty. We call this the “sleep test”.

There are people out there who think: “I’m not concerned with the lowest rate, I want certainty. So, I'm going to lock in for longer”.

That’s a fine decision.

If a shorter, more uncertain interest rate keeps you up at night, maybe you need more certainty.

Some people sleep better knowing exactly what their repayments are each month.

Sure, the 5-year rate is usually more expensive in the long run, but you might be willing to pay that price for a stable interest rate. That way your repayments don’t change every year.

#3 What you can afford

You can’t always afford the rate you want.

I believe in locking in for the 1-year rate. It works for me, but right now the 1-year rate is almost 0.8% higher than the 5-year rate.

On a $500,000 mortgages, that’s $4,000 a year. An extra $80 a week.

If your budget is tight you might need to go for the lowest rate today, even if it’s more expensive in the long run.

Sure, it’s a great idea in theory to say: “I’ll fix the 1-year forever."

But that strategy only works if you can afford it.

So, what interest rate should I go with?

Sure, the 5-year rate is almost always cheaper today. But in 3 years you might kick yourself.

Just like many of us are kicking ourselves for taking the cheaper 1-year rate in 2021.

We saved a bit of money in the first year, but we are paying for it now.

A higher rate today might save you money in the long run.

Interest rates will always change.

So, it’s about at what point you lock it in, and what happens to interest rates over that period.