Would You Put All Your Eggs In One Basket?
Most often, the mortgage economy prefers a lending system that can change as financing ideas evolve. We the consumers want some flexibility in the lending process because not every borrower is a letter-perfect loan applicant. Similarly, not too many lenders, or even mortgage investors, would want to play around with loans outside its safe harbour, because borrowers now have more rights than in the past and the legal protection for lenders that has long been assumed with high-risk mortgages is today less formidable.
Split loans allow you some degree of flexibility and excellent borrowing options through the combination of the benefits of variable rate and fixed rate loans. People with variable rate interest loans have to worry that their monthly amortisations will grow substantially at any time. They essentially have no idea of what the next month’s payment will appear like. Instead, they have to keep enough money in the bank to cover unexpected circumstances.
However, availing of split loans is like having the best of both worlds, the fixed rate portion of your loan gives you the security of knowing how much your repayment amount will be, and at the same time, cutting down your risk exposure to interest rate hikes. The variable rate portion obviously lets you do unlimited additional repayments while giving you the proper flexibility to redraw it at any time. The split ratio is typically up to you but 50:50 or 60:40 splits are the most ideal.
Split loans are useful in times of economic uncertainty, particularly when interest rates are rising. The primary reason behind this is because borrowers are protected by having a portion of their loan at the devalued rate. Borrowers who opted for split loans have the decision that can lead them to pick the mode of repayment for every part of the split. In other words, the fixed loan portion of the loan is saved, just in case interest rates go up. It does not really matter though if rates go down. Another thing is that when interest rates go down which would be best or stay fixed, the borrower can make payments for the variable portion of the loan much quicker.
A split home loan hedges your bet by distributing borrowed funds. It largely depends on how the market behaves. Since you have a fixed rate loan in relation with the adjustable rate, you shouldn’t see any volatile swings in either direction from time to time. While the banks argue that they have to change interest rates to shield their shareholders’ returns, there is little comfort for borrowers who are the ones actually paying the loan off every month. Fixed rates have often been a haven for borrowers who want stability, but as we know, fixed rates have a sting in the tail especially when variable rates continue to fall.
The Australian government unravelled a clever strategy that allowed Aussies buying a home and an investment property to pay off their home loan more faster by channelling all repayments into that mortgage while letting interest build up on the investment loan. It became widespread during the 1990s and early 2000s when banks started offering split loans. Mortgage investors could use the same loan facility to finance the purchase of both their home and an investment property. Under those facilities, all loan repayments were applied to the home mortgage component, but none were allocated to the investment loan. This subsequently reduced quickly, the amount owed and the interest charged on the home loan portion. The interest accrued on the investment property loan increased and compounded, with interest being charged on interest. Hence, this allowed many borrowers to benefit because they were claiming the increasing interest on the investment loan as a tax deduction. But in 2004 this “modus operandi” was brought in the High Court by the Commissioner of Taxation. The court’s decision was that the main purpose of the split loan arrangement was to avoid tax, which effectively put an end to this scheme.
Having the choice of splitting the loan may look good for the borrower’s credit quality. It gives borrowers an infinitely flexible way of spreading their risk of fixed rates. The best way to decide on how the splits should be organised is to have a financial analysis done by a mortgage broker or finance professional. The initial step is to construct a budget to work out how much you can comfortably afford to repay on your home loan. With this methodical approach, the borrower can then perform some analyses to check which loan structure will suit their cash flow best before locking themselves into any loan covenant. If your income is likely to change every now and then, it’s a good opportunity to examine how a split loan could suit your changing circumstances, and this type of facility can give you great peace of mind as well as allow you to manage your finances effectively, especially where you have chosen to repay more every month so you can pay off your home loan straight away.
Like all fixed rate strategies, it is wise to seek the guidance from an independent finance person such as an accountant to explain the nature and effect of locking into a fixed rate contract.
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