Many homeowners who were able to lock their interest rate in 2006 were likely smiling as the rate rose three-fold 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. Variable loan homeowners will find them less expensive even though borrowing costs are rising. This begs the important question: Are fixed-rate loans cheaper or more expensive?
Fixed vs. Variable
Variable rates can be attractive for those who are able to afford higher monthly repayments or need the flexibility offered by variable rates. Variable rates give borrowers the ability to personalize their loans. This is just one advantage. While variable rates generally track the interest rates set by the RBA, lenders aren’t obliged to pass changes on to borrowers. Borrowers will pay more if they have higher rates.
Fixed rates are just that – they are loans whose interest rates are fixed within a certain period. Fixed rates are a guarantee that your repayments will not change over the course of the loan term.
Paul Braddick, ANZ’s head of financial systems analysis, stated that fixed-rate loan rates can result in higher interest rates, while variable rates can be lower. 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.”
What are the rates for fixed and variable loans?
Lenders fund fixed and variable loans in different ways.
Rates can vary depending on many factors.
Fixed loans are financed primarily by banks and non-bank lending institutions. You will pay higher interest rates because lenders are more likely be able to quickly finance your home loan.
Variable rates may be more or less costly than fixed rates, depending on the economic environment. In the last year, Lenders were able to borrow at extremely low rates of interest. Fixed rates were also very low.
Due to sub-prime lending issues, the recent credit crunch in America has increased the cost of borrowing money (money). This is passed onto you, the borrower. People who need to borrow money in the current year will find fixed-rate loans more expensive than those who do not. 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 is BankWest’s mortgage head. He claims that fixed rate rates have experienced a significant change in the past 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 high?
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 asserts that while longer-term bond yields are down, the squeeze on credit market has driven private sector borrowing prices higher. Fixed rate mortgages are now more affordable because of this.
“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 make a change?
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 explains why fixed rates are more expensive than variable rates after they were cheaper for many years.
“I’d say you’ve probably missed the boat on fixed rates. It happened back in
March’s fixed rate for March was 6.99%. Now it’s around 7.79%. Variable rates were at 7.40% in that period. They are now 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, Austral Mortgages general manager, is his real name. Fixed rates might not be as appealing as they were a few years back, but he believes that borrowers may have 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. The rate could rise again in December, and then stay stable for a while. 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.
”Which time is best for it to be fixed?
Fixed rates are better than variable rates for fixing.
rates and there’s a prospect of cash rates going up in the near future. Lending institutions have the ability to access more money at a lower rate because fixed rates are dependent on the credit markets. 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. This can be fixed.
Consider yourself an option.
What are your options
You will decide whether to fix it based on your personal preferences and financial advice.
“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. These funds can be used to offset higher payments in the future. 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.”
When you fix something, be aware of the traps.
Next, you need to consider how long you will keep the fixed-rate loan in place if you are thinking about applying for one.
There are many types of fixed rates. The most common are the three-, five and two year terms. The rate for shorter fixed periods is lower. You have the option to refix the loan for a shorter term or return to the standard rate variable.
Sheales believes that the biggest problem for borrowers is their inability to or unwillingness manage 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 mentioned that you may not be able to make additional payments or pay a lump sum. Before you agree to a fixed-rate long-term, Sheales suggests you take into account all your circumstances.
You can find a lender that offers a great deal by looking at the tables at the back. You can also find the latest information on products on our website.
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.