In New Zealand, fixed-rate mortgages are extremely popular. The ability to fix your interest rate, and therefore your repayments, for up to five years is appealing because it gives you certainty about your day-to-day expenses. You know exactly how much you need to pay each month.
Fixed Interest Rates
However, while your mortgage is fixed, market rates are in a constant state of flux, and when you arrive at the end of your fixed term, interest rates may be very different to when you originally signed up. If they’ve gone up, you’ll be faced with a new higher fixed or floating interest rate. When you’re borrowing large sums of money, even a fraction of a percent increase can translate to big changes in your repayments. If you’re on a tight budget, this can have huge repercussions, from lifestyle changes through to the worst-case scenario of having to sell your property.
What is Tranching?
That’s where tranching can help. In a nutshell, tranching is the practice of structuring your mortgage strategically to protect yourself against interest rate volatility by breaking up the debt into tranches. The concept has been used by businesses for many years to reduce their lending risks, but the residential mortgage market seems to have been slow to adopt the technique. Tranching is something that SurePlan recommends to any clients who need the certainty of cash flow stability.
Tranching in action
To illustrate how tranching works, we’ll look at Josh and Sarah, a typical couple who are working hard to pay off their mortgage on a fixed income. Josh and Sarah have a 20-year mortgage that’s currently on a 4.5% fixed interest rate. They still owe $460,000 on their home, which they are repaying at $2954 per month. Their current fixed rate expires in two years’ time.
Imagine, in two years, that interest rates have risen from 4.5% to 5.5%. On the day their fixed rate ends, Josh and Sarah would face the prospect of having the interest on their entire loan balance increased by a full 1% overnight. Their repayments would go up to $3233 – a jump of $279 per month. That’s a large increase to absorb into a carefully-balanced household budget.
Let’s step back in time and imagine that instead of fixing their whole mortgage at 4.5%, Josh and Sarah tranch it by splitting their $460,000 debt into three equal parts. They fix one third for 12 months at 4.1%, one third for 24 months at 4.5% and one third for 36 months at 4.95%. This brings their overall monthly payment to $2957 – just $3 more than if they’d fixed the entire mortgage at 4.5%. The act of fixing each tranch still provides a level of certainty about their monthly costs, but by splitting the debt into three and staggering the renewal periods, they’ve controlled the amount of lending that is exposed to large changes in interest rates at any one time.
Results
Going forward, as each tranch comes off its fixed rate, it will be fixed for another three years. By timing the initial tranches to expire a year apart, it means that there will always be one tranch renewing each year. Doing this evens out the highs and lows in interest rates and creates a more stable “average” interest rate across the three sections of the mortgage. In other words, it smooths out the financial bumps. Josh and Sarah get the best of both worlds because their monthly payments are fixed throughout the year, and when renewal time rolls around, any changes will be smaller and more manageable.
