Interest rates: to fix or not to fix…
Australia’s Reserve Bank has cut interest rates to their lowest point in nearly 50 years - with more tipped to go. But how much lower can they go? If at all? And what effect will the world financial situation have on rates rising? To fix or not to fix is more than a $64 question!
Last year saw fixed-rate loans in and out of favour as interest rates jumped, then fell – all in the space of a few months.
Banking loan-book data shows that fixed-rate loans went from being around 25% of the market in January, to 10% higher a month later.
Yet by November, Australian Bureau of Statistics’ data was showing that only 2.5% of new borrowers chose a fixed-rate home loan that was locked in for two years or longer.
Fixed loans’ massive popularity slide reflected the official cash position changes from the Reserve Bank of Australia (RBA).
As for the 43,000 borrowers who locked into fixed-rate home loans between March and August last year – just like anyone who takes the punt that rates will keep rising – they have felt no relief as interest rates dropped.
And drop they have.
In July ‘08, for instance, some banks were raising rates to just over 9%. They were doing this due to soaring inflation and increasing cost of funds. The RBA was aggressively increasing rates to stall inflation, with the market view then that rates could go higher.
But by September, they were declining. Fast.
Indeed, the RBA lowered the official rate 5 times between September and now.
And it was only this month that the RBA halted the rate shrinkage.
Currently, official rates are at 3% - a 49-year low. Yet despite this, most analysts and experts believe the cash rate will still drop further, with 2% a figure that keeps popping up. (This would be historic, as 2.99% is the lowest that Australia’s official cash rate has been - not long after the RBA came into being in January 1960, as Australia’s central bank.)
Fixed loans back in favour?
Fixed-rate loans now form a record-low share of the mortgage market, but that might be about to change.
Why?
Because most banking analysts believe that while rates will likely drop again this year - with timings predicted from mid year to the end of the year - they could rise again. And quickly.
What are the benefits of fixing?
Even if interest rates don’t rise “quickly”, the fact they will rise again is a given.
The questions - as always - are over what time period, and to what level.
Choosing a fixed-rate loan has benefits in that you turn a variable cost (so unknown, as how high rates will go is not known) into a fixed (so known) cost.
The plus is that it makes budgeting so much easier: you know exactly what’s coming in and what’s going out cash wise.
However, choosing to fix rates is, in effect, a gamble that rates will rise and then stay above the fixed rate for a substantial time.
And if they don’t, then you pay the locked-in fixed rate anyway.
What are the benefits of variable?
Banks aren’t always quick to pass on interest rate cuts when the RBA drops the official rate, but they do pass them on. Eventually, and most of it.
For instance when the official rate fell to 3.25% in February, variable-rate borrowers saved about $185 a month on a $300,000 mortgage. Of course, that has fallen again, with the current official rates at 3%.
Yet there are many who won’t forget the 1980s, when high inflation was feeding into prices and wages. In 1989, variable mortgage rates peaked at 17%. Housing affordability sank.
(Lower interest rates mean greater housing affordability - as furious building activity in the past 15-odd years has shown.)
Having a variable interest rate means you have to “go with the flow” more: you gain the benefits in times such as now, but not in times of just a year ago – and certainly not in 1989.
What to consider about fixing
In the end, as with all investments, “time” and your “other needs” (including life goals) are major criteria in choosing whether to fix your interest rates. In the case of a mortgage, how long you expect to have the debt will have a strong impact on whether you choose to fix or not. And if you do, when you choose to do it, and for how long.
Is the peace of mind of known payments more valuable to you, say, than the extra money spent if your fixed rate turns out to be higher than the variable rate after 5 years?
Are your budgeting skills strong enough to allow extra money towards your mortgage when interest rates rise? Without impacting your lifestyle? And without racking up a credit card debt?
How are loan rates costed?
Variable-rate loans present little risk to banks in that they add a retail margin to the RBA’s official cash rate.
A fixed-rate loan, however, does present a risk to the bank: basically they are gambling on what their future funding will cost them – so for how much they will be able to buy money (on the money markets); then they add a retail margin.
Naturally they build “fat” into their fixed rates, guarding against carrying the risk of money costing more during the loan.
Industry thoughts
As stated earlier, most in the banking industry believe rates will drop a little bit further, with 2%-2.5% tipped as the official cash rate, anywhere from mid year to the end of 2009.
John Symond, executive chairman of Aussie Home Loans, has said people who lock in a fixed rate within 0.5% of 40-year record lows will have done well with interest rates.
A spokesperson for Loan Market Group has said now is the best time for borrowers to fix a home loan - despite the further expected rates cuts.
David Kaplan, a director of Rate Detective, has said there was no guarantee interest rates wouldn’t rise again soon, unexpectedly.
Interestingly, in April, the Commonwealth and Westpac banks increased rates on fixed-rate loans - generally seen as a sign that borrowing costs are near their low point.
It’s generally considered that the time to fix interest rates is when the cycle has reached its nadir, and so the next move will probably be up.
But no one has a crystal ball.
Break costs
It’s also worth considering that getting out of a fixed-rate mortgage is rarely cheap.
“Break” costs generally depend on 3 factors: the fixed interest rate compared with the current wholesale lending rate, the term remaining and the amount borrowed.
Conclusion
A 2007 mortgage industry survey found that 83% of the time, borrowers were better off with variable-rate loans. That’s a lot, but it still leaves 17% of the time when borrowers are better off with fixed rates.
In essence, having the right loan structure for you can help you through rate changes, improve your investment opportunities and allow you to take advantage of the economic environment.
Of course, the wrong structure won’t help on any level.
So that’s why, again, as with any investment, you shouldn’t choose to fix - or not to fix - based on emotion, assurances from those who purely sell the product without an understanding of your individual circumstances, or the “herd mentality” (as in, what everyone else is doing).
With the right approach, this seemingly small decision can reap you benefits. Talk to Summerhill Financial Services to discuss your individual circumstances.
Tags: fix, interest rate, mortgage