Homeowners who fixed their interest rates before 2006 were probably sitting with smug smiles on their faces as rates went up three times last year.
Rates have only gone up once so far in 2007, but the effect of four rises (1%) in two years has seen less fortunate people struggle to cope with the hikes in monthly repayments caused by the Reserve Bank of Australia’s (RBA) efforts to keep inflation under control.
As usual, it’s the humble homeowner with a variable mortgage who comes off worse in an environment where big business, especially mining and resources, is bringing wealth into the Aussie economy and pushing up consumer spending. The resultant increase in the cost of borrowing is an attempt to cool that spending, but it also means homeowners with existing variable loans find them more expensive. The question is: are fixed rate loans a cheaper or better option?
Fixed vs variable
Variable rates are attractive to people who are in a position to make extra repayments and need the flexibility that this type of loan offers. One of the biggest benefits of a variable rate is that it allows borrowers to customise their loans. While variable rates generally track the interest rates set by the RBA, lenders aren’t obliged to pass changes on to borrowers. However, if the rates go up and the lender decides to raise the rates on the loan, then borrowers will face higher repayments.
Fixed rates are just that – they are loans whose interest rates are fixed within a certain period. They offer some form of security in that your repayments will stay the same for the duration of the fixed term.
The downside of fixed rate loans includes the potential to be locked into a higher rate while variable rates are cut, according to Paul Braddick, head of financial systems analysis with ANZ. He adds: “Most fixed rate loans include penalties for ‘pre-payment’. If there’s potential for pre-payment, but a fixed rate loan is attractive, it’s advisable to split the loan into a fixed component and a variable component.”
How are fixed and variable loans priced?
Fixed and variable loans are funded differently by lenders and therefore
the rates you pay depend on a variety of circumstances.
Fixed loans are largely funded by money raised by banks or non-bank lenders in the global debt markets. If lenders are able to finance their home loans cheaply and easily, then the rates you pay as a borrower reflect that.
Fixed rates can be cheaper or more expensive than variable rates depending on certain economic circumstances. During the past year, debt has been freely available to lenders at a cheap rate, meaning fixed rates were low.
The recent credit crunch across the world (caused by sub-prime lending concerns in the US) has contributed to the cost of debt (money) becoming more expensive. That cost is passed on to you, the borrower, so those people looking to take out a fixed rate loan now will find it significantly more expensive than earlier in the year. Pricing depends on individual institutions, but you’ll find that even though cash rates have also risen, a straight, undiscounted fixed rate may now be more expensive than variable rates with many lenders.
John Rolfe, head of mortgages at BankWest, says that fixed rates have been affected dramatically in the last few months.
“Fixed rates are funded from the bond market, and back in March, appetite for bonds was such that they could be purchased at a much lower rate,” he explains. “The sub-prime crisis plus global inflationary pressures have caused a rise in the swap and bond market rate, which affects fixed rates.”
Are fixed rates too pricey?
Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors, doesn’t think so: “I have no reason to think that fixed rate mortgages are overpriced. The current fixed rates on offer reflect current market conditions and here the trends are mixed.”
Oliver says the longer-term bond yields have fallen, but the squeeze in credit markets has pushed up private sector borrowing rates, and this has had an impact on fixed rate mortgages currently on offer.
“Right now the rates on fixed rate mortgages are running below the banks’ standard variable mortgage rate (8.32%), but around the base or discount variable rate (which is around 7.82% depending on the mortgage lender),” says Oliver. “This seems about right, given current market conditions. Fixed rate loan rates may start to decline once credit markets return to normal.”
Is it too late to fix?
In Oliver’s view, the risk for the variable rate in the short term is still on the upside – because economic growth remains strong and the RBA is fearful that this will yet again push inflation above the 2–3% target range.
“In this context, given that fixed mortgage rates are below or around current variable rates, it makes sense for borrowers to fix a portion of their mortgage, particularly if a borrower will likely run into trouble if there are any more rate hikes,” he says.
“However, for those less stretched financially, I’d only be inclined to fix for a short period – say one year – and only a portion of the loan, because we’re at or close to the top of the interest rate cycle and rates may start to fall in a year or so, particularly if the US economy remains weak, leading to a softening in global growth.”
Rolfe points out that fixed rates are now more expensive than variable rates after several years of being cheaper.
“I’d say you’ve probably missed the boat on fixed rates. It was only back in
March that the best fixed rate on the market was around 6.99%. Now it’s around 7.79%. At the time (in March), variable rates were 7.40% but now are at 7.70%. The market was definitely in favour of fixed rates earlier in the year, but that’s gone the other way now.”
Paul Bonaventura, general manager, Austral Mortgages, says fixed rates are not as attractive now as they were a few months ago, but borrowers may not have quite missed the boat.
“Some fixed rate products have climbed three or four times in the last four to five months and aren’t as attractive as they were,” says Bonaventura. “When cash rates move, variable rates will always go up, but fixed rates are determined by the lender. I think rates may climb again in December then remain stable for some time. If that’s the case, it’s more of a reason why people should look at fixing their rates, to guard against another impending quarter per cent rise.
”When is the best time to fix?
Generally the best time to fix is when fixed rates are cheaper than variable
rates and there’s a prospect of cash rates going up in the near future. As fixed rates are reliant on the debt market, that means a time when money is available to lending institutions cheaply. This is also usually at a time when the economy is performing well, which means that variable interest rates are likely to go up as the cash rate increases to keep inflation in line.“
The best time to fix a home loan is when the interest rate cycle is close to bottoming, ie after an extended period of falling rates and when economic conditions are just starting to improve,” says Oliver. “On this basis, the best time to fix was a few years ago when fixed mortgage rates were a lot lower.
”While the best time to fix may already have passed, the threat of further rate rises looms large. As a consequence of this, fixing could still
be an option.
What are your options?
Regardless of economic advice, the decision to fix or not to fix depends largely on personal preference.
“My personal opinion is that if you can afford to stay on the variable rate, then stay, as it offers a much larger range of options,” says Luke Sheales, national sales and distribution manager with Mortgage House. “Fixed rates are generally much higher than the cheapest variable rate; you’d be much better making repayments as if the loan was fixed and saving the difference to your redraw. Then, at a later date, use these funds to offset a higher payment if that scenario happened. This allows you to keep all the features of a variable loan and the security should interest rates go up.”
If you’re the sort of person who wants to know exactly how much you’ll be shelling out each month for the next few years and values that certainty above the potential of saving some cash, then fixed rates are for you. If you can’t bear the thought of missing out on a potential rate cut, then you should probably consider going for a variable rate loan.
Steve Blinkhorn, head of home loans at St.George, advises borrowers to consider their own preferences before making a decision.“
Customers who are happy to lock in their repayments and not be too worried about what rates do are candidates for a fixed rate loan,” says Blinkhorn. “We encourage customers to have a bit of both – that’s splitting the loan as half fixed and half variable. You can maintain more flexibility with this approach, so you don’t put all your eggs in one basket.”
Traps to watch for when opting to fix
If you do decide to go for a fixed rate loan, the next question you face is how long do you wish to fix your loan for?
Fixed rates come in a variety of shapes and sizes, the most common being two-, three- and five-year terms. Right now, the shorter the fixed period, the lower the rate. At the end of the fixed period you can refix your loan for another period, or let it revert to a standard variable rate.
Sheales says the biggest trap for borrowers is time. “People tend to fix their loans for three or five years and that’s too long. Think back five years and I bet in most cases you didn’t think you’d be doing what you’re doing today. If you fix for a lengthy period and then your circumstances change and you need to break the fixed period of your loan, you’ll most likely be up for extensive break costs.”
Sheales adds that you could also be restricted or not allowed to make extra or lump sum repayments on your loan, so he advises that you need to consider your situation carefully before committing yourself to a lengthy fixed rate term.
Use the tables at the back of this magazine to find a lender offering a good deal or visit our website www.yourmortgage.com.au for the latest details on product information.
Also check out the results of this month’s Editor’s Choice Award, where we feature the best value three-year fixed rate loans in Australia.