Interest rate movements have always been hard to predict, but even more so now that more lenders are acting independently of the RBA. Michael Lee, mortgage guru and author of Mortgage Free Debt Free, examines both sides of the argument to help you decide whether you should jump on the fix bandwagon.
A few years back, I wrote an article for Your Mortgage called ‘The Fix is in’. I started it like this: “Most people with a pulse and even half a brain realise by now that no individual is certain exactly what the future holds for the economy in the next two to three years. This begs the question why some of the ‘experts’ are suggesting you should ‘fix’ the interest rate on your mortgage, as others urge you to stay ‘variable’.”
Three years on, that statement is as true today as it was back then. Australia, the experts are telling us, is running a two speed economy. One “booming” which by all accounts should drive interest rates up and another, the one that you and I live in, just sort of bubbling along – perhaps even doing a little worse. The rather flat, ‘non-mining economy’ puts pressure on the Reserve Bank (the RBA) to keep interest rates on hold, or even consider reducing them. The problem that we should all now understand is that the RBA no longer controls whether the interest rate on your mortgage will go up or down, your lender does. Lenders have been twiddling the knobs on interest rates independent of the RBA for almost four years now.
Removing this uncertainty is what fixed rates are all about – locking in your interest rate and locking in your loan repayments for a certain period of time.
So the sixty-four dollar question is should you fix part of or your entire loan?
For the most part, the banks and the brokers are keen to play up this uncertainty, as from July 1 2011 the government introduced a new challenge for borrowers - the abolition of exit penalties on some mortgages. Yep, that’s right, some mortgages. Although it is widely promoted that exit fees have been banned on all new loans, it is simply untrue. Lenders can still legally penalise you for exiting a fixed rate loan during the fixed rate period, only it’s called a break fee, can easily be upwards of $10,000 and you won’t ever see it written in your loan contracts as a dollar amount. It skirts the government’s exit fee ban, which has suddenly made fixed rate loans much more exciting for the banks and brokers.
Fixed Rates are the new exit penalty, which makes it harder, than ever before to get pro-consumer or even impartial advice on whether you should fix some or all of your loan. Like every decision, there will always be for and against opinions. Listen to each argument and you will probably hear compelling and justifiable reasons based on statistics, economic trends, savings, and dollars and cents, but what does that really mean to you? Should you think about taking a fixed rate mortgage over variable? Yes. Always. But that doesn’t mean you should actually do it.
Like many Australians, I am a big fan of variable rates. For most of my property investment life, which now spans 24 years (just where did that time go?), I have only ever had variable rate mortgages. That is except for one brief stint a few years ago where I switched a couple of my investment loans to fixed rates. But again, does that mean you should too? The short answer is a definite maybe, which is about as useful as a dust bowl in the middle of the desert. But don’t flip the page just yet. By the time you finish reading this article, you should have a better understanding of the significance of your decision and a much clearer answer based on your needs. Which is what this should be all about. You.
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Let’s talk about risk
Risk is the chance of an event happening. Impact is the result of that event occurring. Although risk and impact go hand in hand when you make a decision, they each have a greater or lesser ability to affect your decision, depending on your own personal attitudes and what is at stake. Regardless of whether you choose to acknowledge it, risk and impact are present in every decision you make.
In the case of your mortgage and its rate type, you have a simple decision. Either you fix your interest rate, or you do not, so you need to consider both sides of your decision if you hope to make the right decision. If you don’t fix, your interest rate will be variable, which is to say, your lender can change it either up or down, by as much as they like, any day of the week and therein lies the risk of taking a variable rate mortgage. So the sixty-four dollar questions are, will they, and if so, by how much?
The risk and impact of going variable
If you are like most people with a mortgage, the daily interest rate directly affects one of your most significant household costs – mortgage repayments. Assuming you have a reasonably reliable, steady income, these repayments may also have perhaps the most significant impact on your ability to live a happy life. A low repayment gives you more money to live the way you want to and do the things you need to (‘disposable income’ in economic terms) and sensibly enough, a higher repayment creates restrictions on how you live. By taking out a variable rate mortgage, you will relinquish a little or a lot of the control you have over your ability to live a happy life.
In the year between October 2009 and November 2010, interest rates on competitive variable rate mortgages rose by around 2% pa. Many experts would have considered that increase unlikely and assessed the Risk of it actually happening as low. No matter whether you may have assessed the risk, the fact of the matter is, it happened.
During this period, some people raced to fix, others were able to ride it out, and many lost their home or other property. Some are still struggling. Each of these people experienced a different impact and that impact to some was a lot worse than it was to others.
Although an increase of 2% pa may not sound like much, it is very sharp when you put it in perspective. So let’s try. If you close this magazine now and talk with the right people, you will have no trouble finding a variable rate mortgage with a comparison rate between 6.9% and 7.3%, even with at least three of the ‘big four’. So let’s assume you did that and went for the top shelf option of 7.3% p.a. If the interest rate cycle from October 2009 repeated itself the impact to you can be worked out using this formula:
Total rate increase / current rate x 100 = Increased interest cost or;
2% / 7.3% x 100 = 27.4%
This means that in simple terms, your interest costs will jump by almost 30% in 12 months. Yikes.
As a borrower this 30% increase would cause an impact ranging from barely noticeable to losing the farm so it is important to individually consider how this would affect you. If you are more up the ‘barely noticeable’ end of the spectrum, you can probably relax. However if not, you really need to do some serious thinking about the risk. So what is the risk of it happening again? As uncomfortable as it may be to read, nobody really knows, however it is fair to say the risk is higher today than it was 15 years ago for a number of reasons.
Not so long ago, the interest rate on a variable rate mortgage moved in line with the ‘state of the economy’. When the economy was booming, wages would go up, jobs would go up and so would the interest rate on your variable mortgage. That made it somewhat predictable and meant the historical risk of a variable rate was relatively low, especially if you were borrowing within your limits.
Much of this predictability came from the capacity of Australia’s central bank, the RBA, with help from the government and also market competition, to indirectly control the interest rate that lenders charged you on your mortgage. When the RBA increased the target cash rate by 0.25%, lenders increased your mortgage interest rate by the same amount. When the RBA reduced it, lenders also reduced it by the same amount and of course when the RBA left rates unchanged, so too did the lenders.
However in October 2007, BankWest, now owned by the Commonwealth bank, broke ranks and started moving their interest rates up, independent of the RBA. What started out as an unnoticed blip quickly became common practice for many lenders. ANZ was the first of the big four to try it, the Commonwealth Bank following not long after. Each of the majors did it a second time and discovered that, although they got a bit of bad press, borrowers continued to flock to them and they still made gargantuan profits. So they did it again.
Since that time, a bunch of things have happened empowering lenders, in particular the big four, to drive interest rates up on variable rate mortgages. It is important to understand that this is despite RBA signals that in the past would have reduced or held interest rates steady. So now, in addition to the historical triggers that affected rate movements, you have a newly executed practice of lenders striving to out-profit each other by moving independently of the RBA. The implication to your risk is that even when the economy is down and the RBA suggests rates are on hold or may even fall, lenders may act differently.
However it is not all downside for the variable rate mortgage. Providing you are able to handle the risk and impact of rate increases, you will generally gain powerful benefit from a lower daily interest rate (although this is definitely not always the case); more flexible offset options and a less costly option to vote with your feet when your lender lets you down.
The cost of going fixed
The main reason for taking a fixed rate mortgage is it eliminates all the risk to you that comes with a variable rate mortgage, offering you a fixed repayment amount, with a known interest cost for a definite period of time. This means there is simply no way you will lose the farm or be arguing over money because of interest rate movements on your home loan during the fixed rate period because, quite simply, the rates repayments and costs, do not change. However that protection is usually not free.
Generally speaking, fixed rate home loans will cost you anywhere between a little and a lot more than their variable rate mates. If you didn’t close the magazine to find a competitive variable rate a little earlier, then thank you for ignoring me on that idea. However, you could close it now and may find a three-year fixed loan with a fixed term comparison rate of between 6.2% and 6.5% - although it’s odds on that fixed rates will have changed, at least a little, between the time I wrote this article and the time you are reading it. Importantly, a ‘fixed term comparison rate’ is the comparison rate for the actual fixed term, not the life of loan comparison rates that lenders quote and that skews results. So at this frozen moment in time it is actually around 0.5% per annum cheaper than sticking with variable. However that assumes rates won’t fall, you don’t plan to max out extra repayments and you don’t really want to change anything significantly on your mortgage for the next three years. If rates fall, your mortgage will probably wind up costing you more and if rates rise, you’re locked in and safe and who knows, it may even wind up saving you some interest as well.
However, if you are thinking about fixing, saving interest should be the last thing on your mind. That is not what it’s about and people who focus on this aspect miss the point. A fixed rate mortgage is an insurance policy against financial pressure brought on by mortgage rate movements, especially rapid ones that could cost you the farm.
In the last 15 years there have been two periods of sharp rate increases. The recent one kicked off in October 2009 and another in August 2007. There have also been two periods of moderate increases starting in November 1999 and again in May 2006. So again, the point is, it does happen and you should think through your position carefully before deciding what is right for you.
When is the right time to fix?
Your mortgage is a very large financial obligation. For most, it is the largest and most costly financial decision of their life. Careful consideration and regular review are critical components to getting the most from your mortgage and making sure it works for you, not against you.
At each review you should ask yourself whether the loan and structure you have is working for you, whether you have achieved your financial objectives and how you can improve on those objectives.
Whilst there is never an absolutely right time to fix your loan, it is one aspect to consider at each review milestone you set for yourself. Ideally these should be every three months or so for variable rate loans and three months before the expiry of any fixed rate loan. This doesn’t mean you should change lenders every three months, in fact you should plan to be with a lender for at least three to five years.
The 50/50 con
Part fixed, part variable. In itself it’s a valuable approach for some people; however the default notion of splitting 50/50 stacks the odds against you. If you have done your own sums and genuinely feel that this is the right balance for you, by all means do it.
However make sure they are your sums, not that of a lender or mortgage broker. These pro-debt businesses commonly recommend 50/50 because it’s an easy sale to uncertain borrowers. Like the now ‘banned’ exit penalties, the fixed proportion keeps you locked in no matter what happens, which equals more profit and commissions all around.
There are only two reasons to consider splitting between fixed and variable. The first is that you are a good saver and want accessible offset facilities, which can be hard to find amongst competitive fixed rates. The second is that you only want partial protection against rate increases.
A final thought
There is no doubt that in a climate of so much uncertainty, cheap fixed rates have become increasingly attractive. However you should remain mindful of the serious limitations of fixed rate loans before you race to sign on the dotted line. Check to ensure what limitations apply to extra payments and redraw and remember, just like the chance that rates will rise, there is a chance they will fall as well.
Regardless of whether you choose a fixed rate mortgage or not, how you arrange your loan and the features you choose will have a significant impact on your finances and your life, whether you notice it or not.
Remember that even small, regular amounts of money really add up. Make sure you understand why you have the loan that you do, whether the features and benefits really match your needs, and then get it at the best possible price you can.
After all, it’s your money.
Michael Lee is the author of Mortgage Free Debt Free and the managing director of independent finance research company KeyFacts.