Benefits of fixing and prepaying interest on loans now
This week, many geared investors will be finalising their end-of-tax-year strategies to fix and prepay the interest on their loans for the next 12 months.
There are two possible benefits from doing so. First, prepaying the interest for this period allows individuals to claim this expense as an immediate tax deduction in the current tax year. This advantage increases with the investor's marginal tax rate.
For a top 46.5 per cent marginal rate-payer, almost half of the interest prepayment will be recouped via a lower tax bill. In some cases, the benefit comes via a refund of part of the pay-as-you-go tax instalments on wage income earned during the year. In others,the prepayment of expenses will help reduce the tax payable on the current year's investment income.
The second benefit of fixing the interest rate on a loan for an agreed period can be even more important than the taxation advantages of the prepayment of expenses. Financial institutions are not charities but in the past there have been many examples of where there assessments of future interest rate movements have turned out to be incorrect.
Fixing an interest rate for an extended period involves significant risks for the borrower if interest rates fall more than expected. In periods of falling interest rates, unless the fixed rates on offer are well below the current variable rate, there will be higher costs involved in the decision to fix the rate.
Even so, in certain situations such as borrowers facing cash-flow problems, taking out a fixed-rate loan may still be a sensible decision. The reason is simply that a fixed rate provides certainty about the interest charges for the period the loan is fixed. Fixing the rate amounts to taking out insurance protection against unforeseen adverse movements in the variable interest rate.
The decision to fix the rate or not will be greatly affected by what's on offer. Borrowers have access to fixed-rate loans for as long as three or even five years at rates up to 1 per cent a year less than the current variable rate.
The assumption of the institutions offering these rates is that the cash rate and variable rates are likely to fall further. This is no certainty despite widespread expectations that the Reserve Bank will reduce rates further.
Mortgage providers are reporting increased interest in fixing interest rates now that fixed interest rates are at historically low levels. Certainly the risks of fixing an interest rate at 5 per cent year are much lower than they were at about 8 per cent not many years ago.