According to the Australian Bureau of Statistics approximately 80% of all home loans in Australia are on variable interest rates, as opposed to fixed.
Whether you should choose a variable or fixed rate (“the rate debate”) depends on your specific circumstances, however variable rates are about four times more popular… and there are good reasons why.
Let’s start with a brief explanation of the two loan products.
Variable rate loans
With a variable rate loan the interest you pay fluctuates roughly in line with the Reserve Bank of Australia’s (RBA) cash rate. The RBA uses the cash rate to control inflation so when inflation is getting too high (typically when the economy is doing well) the RBA raises the cash rate, and when inflation is low (usually the economy is weak) the cash rate comes down.
The RBA meets once a month to set the cash rate and because all interest rates in the market are correlated with this rate, the cost of borrowing either becomes cheaper or more expensive when the rate changes.
The below chart of the RBA cash rate from 1990 to 2015 — where it has fallen from 17.5% to just 2.0% — shows how volatile the cash rate can be.
Between April 2002 and August 2008 the cash rate increased from 4.25% to 7.25%, a rise of 3.0%. Then the Global Financial Crisis hit and the cash rate fell by 4.25% in just 8 months.
Since October 2011 the cash rate has fallen by 2.75% (to the historical low of 2.0%, where it is as of August 2015). On an average $300,000 variable rate mortgage, this 2.75% fall would equate to lower mortgage repayments of $456 per month.
Fixed rate loans
Regardless of any fluctuations with variable rates, when you choose to fix the interest rate on your home loan you lock in a rate which doesn’t change for the duration of your fixed term, usually one to five years.
The benefit here is that the fixed rate protects you from rising interest rates which would otherwise increase your monthly repayments. You get certainty and peace of mind.
Financial considerations and flexibility
Financial outcomes and flexibility are the two key considerations when deciding between a variable or fixed rate loan.
Financial considerations
If you choose a fixed rate loan and interest rates rise during your fixed term, then there may be a financial benefit of having locked in the fixed/lower rate (Scenario 2, below). On the other hand you will be worse off if the variable rate falls and you’re stuck with higher repayments (Scenario 3).
Consider how fixed interest rates are actually set
What a lot of people don’t consider is that fixed rates are set based on the expectations lenders have on interest rate movements over the fixed terms.
In the hypothetical situation illustrated below, the current variable rate is 5.45% and the 5yr fixed rate is 7.0% (1.55% higher). The lender clearly expects that interest rates will rise over the next 5 years and therefore they have priced their 5yr fixed rate accordingly (e.g. if rates do rise then the higher fixed rate you committed to at the outset will benefit the lender).
So rising interest rates alone don’t mean that you’re better off with a fixed rate, it’s the magnitude of these rises relative to your fixed rate that’s important.
If the variable rate increases from 5.45% to 6.45% (Scenario 2, below) you’re still financially worse off for having locked in the 7.0% rate. In fact even if the variable rate increased to 8.45% over the 5yr term, a full 3.0% higher than when the loan was established, you would have still been better off under the variable rate. Your break even is 8.55%, Scenario 4.
To be financially better off in a fixed rate product, not only does the borrower need the variable rate to rise during their fixed term, the rise needs to be higher than what the lender was initially anticipating.
Interest rates are difficult to predict however lenders have access to more data and decision making tools than any individual borrower, so the odds are stacked against borrowers, and the lenders usually win.
When do borrowers fix their rate?
A lot of borrowers look to fix their mortgage rate when there’s a lot of talk/expectation of interest rates rising, but as you can now understand this is probably the worst time to do it — because that expectation would be factored in to the pricing, making it more expensive.
Note that in the first illustration the 5yr fixed rate was actually lower than the current variable, implying the lender’s expectation was that rates would actually fall – this is probably the best time to select a fixed rate because it’s relatively cheaper.
Consider your personal situation to make a well informed decision
Provided below is a useful table showing how the above calculations in the illustrations have been made.
You can enter your loan amount and different variable and fixed rates in the green boxes, and then see what you stand to gain or lose under different interest rate scenarios in the yellow boxes.
What variable rate you have been offered, or if you already have a mortgage what is your current variable rate? How does this compare to the current fixed rates available in the market?
Flexibility considerations
As we’ve discussed, the price you pay for a fixed rate loan is based on the lender’s expectation of how the variable rate will move over the fixed term period. Emphasis on ‘the fixed term period’ — e.g. all of it!
If you choose a 5yr fixed rate loan but then decide to sell or refinance after 2 years, breaking the fixed rate loan is going to involve break costs (note that the government ban on exit fees only applies to variable rate mortgages taken out after 1 July 2011).
If you’re looking to sell or want to stay in touch with the best deals on the market, fixed rate loans are probably not right for you.
Similarly, you may be interested in strategies like making extra repayments to pay off your loan faster (this post explains why), or you may be interested in features like an offset account to reduce your interest payments.
But the bank didn’t consider these issues when originally setting your fixed interest rate either, so expect that by adding such options/features, you are again likely to be up for additional costs.
Here’s a recap of what we’ve covered so far
This explains why only ~20% of Australian borrowers have fixed rates — the odds are stacked against them and they have limited flexibility in terms of product features.
Other considerations
Be careful of high ‘revert rates’
If you commit to a fixed rate loan, at the end of the fixed term you can either fix again (based on the fixed rates available when the initial fixed term ends) or otherwise have your loan revert to a variable rate. This revert rate is often high so if you don’t do anything about it your interest payments for the remainder of your loan could be unnecessarily high.
Splitting your loan may be a good option
Just like any diversification strategy splitting your loan (e.g. 50% fixed, 50% variable) may be a wise option as it enables you to benefit from the advantages of each loan product in their relevant proportions. Most banks give you the option to split (in any proportion) at no extra cost.
Things to consider if you do choose a fixed rate loan
- consider how important it is for you to have the flexibility of paying your loan off faster or ending it within the fixed term
- look for fixed rate offers that at least allow for a limited amount of flexibility, e.g. additional repayments
- understand in advance the costs you’ll be up for if you need to break the fixed loan
- choose a fixed term based on your genuine needs, not just on the lowest fixed rate in the market
- when your fixed term is a few months away from ending, avoid unnecessarily high interest payments by comparing new fixed and variable rates in the market, and either renegotiating with your existing lender or switching to a new one
Whatever loan you choose, do you homework and make sure it’s the one best suited to your needs.
