Interest Rates: What's the Best Strategy?

An Interview with Graeme Fowler

About Graeme Fowler: - Graeme is one of New Zealand’s best known investors and educators. He has been investing in property for 20 years, during which time he has purchased approximately 180 properties and sold 140 of these. He is author of the NZ bestseller "NZ Real Estate Investors' Secrets" first published in 2003, and updated in 2008.

Graeme’s property activities have included ‘wraps’, renos, trades and buy and holds. Currently his main strategy is to pay down loans on his remaining mortgages as quickly as possible. Graeme resides in Havelock North in the Hawke’s Bay. He is also a business owner and has past experience as a real-estate salesperson and mortgage broker. Other types of investing for Graeme include commercial property, shares, forex, gold & silver.

Interest Rates
…my view on how to take the best advantage of the current market
There has been a lot of talk lately about interest rates on mortgages. From July 2007 until July 2008, the official cash rate was sitting at 8.25% without change for a whole year. And then from July 2008 to March 2009 it dropped 5.25% down to only 3.0%. This means mortgage rates have come down significantly, although not to the same extent as the OCR drop, but they have come back 3% or so from what they were, less than a year ago. This means that people that have locked in their rates a year or two ago for 3 - 5 years will be paying a lot higher rates than what new loans are being done at now.

So what can you do?
It is always easy in hindsight to see what you could have done. A lot of people with these rates fixed for 3 and 5 year rates would now be wishing they had paid a small break fee in July last year and went on a floating rate until now, and then locked in the rates for 3 or 5 years.  It is a bit of a gamble fixing interest rates, sometimes you will win, and sometimes you won't, it's just a fact of life.

One thing you may be able to do is something I've done on about 12 of my loans, and that is to pay 5% off the principle of the loan without penalty. In one case I paid off this 5% amount on 7 separate loans and the amount used to pay it off was fixed at a lower rate under 6%. You can do this annually, and it makes sense if you can pay 5% off the principle without penalty if you have spare cash available. Otherwise you may be able to borrow the money, and finance it with a separate loan, or a revolving credit type facility at a lower rate.

P&I vs Interest Only.
I am even more convinced than ever that it is best to go P & I on all mortgages, as opposed to interest only. I want to get all my properties paid off as quickly as possible, then when there is no mortgage on them, it doesn't really matter what prices do

If you have an investor that just uses the ‘buy and hold’ strategy and has been investing for a few years, should it matter if the market price of their properties goes up or down in value from time to time over the next 20 - 40 years?

The answer of course is no. But what makes it matter to them is when they decide to use ‘interest only’ loans, as opposed to P & I loans. Now they are forever hoping, maybe even praying – for ever increasing prices.

Newer investors will often ask ‘is now a good time to buy, or do you think I should wait until the market goes down more?’ One of the biggest problems I see with property investment is that people go into it for the wrong reasons, or with their own assumptions – and not even knowing they are assumptions.

The biggest assumption of all is that ‘property will always go up in value’. The majority of investors rely on future capital gains before they make any real money. Starting with the assumption that prices will forever keep going up, many people decide to finance their properties using an interest only loan, as opposed to a P & I loan. With an interest only loan, you do get a few dollars extra a week in cash flow, but the property never gets paid off unless you pay for it from somewhere else. The investor relies on their rental property forever going up in value, thereby gaining more equity in the property, which they often take out again by refinancing, and then buying further properties. This now takes them back up to a similar debt/equity ratio as when they first bought the property. This can go on as long as they continue to invest in property, forever refinancing when prices go up and therefore are always heavily geared.

To me, this is a dangerous strategy and one I’m personally heavily against. If they truly are a ‘buy and hold’ investor for the long term, I will often ask these investors if they think there is any possibility of prices dropping by 20 - 30% anytime over the next 25 or so years? Of course the answer is that it is possible and it’s already happened in many other countries in the past, and to a certain degree here in NZ recently. So, if there is always this possibility, why would they risk all they have on it not happening? All that would need to happen is that you are geared at 80 - 90% over your entire property portfolio say in 10 or 15 years time, and the property market then suddenly slumps 30% within a year or two. This could happen for any number of reasons including a change in government policy, world-wide share market crash, baby boomers retiring etc, etc. Now, because of the reduced equity in your property portfolio, your bank manager wants you to come up with at least $200,000 by the end of the month, as he considers you are too highly geared and too much of a risk for their bank. You can’t even sell these properties now for what the mortgage is on them, so you’re forced into bankruptcy unless you can come up with the necessary cash to reduce your debt/equity exposure.

Property investment can be so simple, and I think because it is so simple, some people want to complicate it, and end up losing money long term. Any investor can make money, or think they are doing well in a rising market, but will their rules and strategies work equally as well in a down-trending market?

I’ve been investing in property for about 20 years now and believe anybody starting out today can do as well and probably a lot better than I have done. That is as long as you stick to the basics and remember that all the tenancies you have are like extra little workers out there working just for you, bringing you in money each week to pay off your mortgages. It is like a form of time leverage, the more incomes you can create from these tenancies, the wealthier you will become, providing you stick to these simple rules above.