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Fixed Rate or Variable Rate mortgage? How should I choose?

With interest rates on the rise, many people are naturally looking to fixed interest rates as a way to protect against further rises.

But is that the right approach now or has the horse already bolted?

What is interest?

Interest is what you pay to borrow someone else’s money. The interest rate is simply the amount you have to pay for each dollar you have borrowed for each year you have the money. It is usually expressed as a percentage (or cents in the dollar). A 3% interest rate, for example, means that you will have to pay three cents for every $1 you have for each year you have it. 

Australia, unlike the USA, is predominantly a variable rate mortgage market – historically more than 80% of new mortgages have an interest rate which varies from time to time.

In theory, this means that lenders can raise their variable interest rates whenever they wish. In practice, competition and the ease with which you can refinance your loan keeps then relatively honest.

The alternative is a fixed rate loan where the rate is fixed for an agreed period. In the USA 15- or 30-year fixed rate loans are common. But not so in Australia, most lenders will only offer fixed interest rates for periods of one to five years. 

Most lenders will allow you to choose either a fixed or variable rate or a combination of both. So how do you know what’s right for you?

What’s the difference?

Variable Rate

This is the flexible option. The rate you pay can vary from month to month, but you are free to make additional payments, have the benefit of an offset account, or move banks as you choose.

The upside is that when market rates fall, so too will your monthly payment. Alternatively, you could maintain your payment and repay your loan quicker. 

The downside is that the rate may increase, potentially a lot. So, you need to think about you would cope if your rate went up by 1%, 2% or more. How much buffer do you have in your budget? Would the impact be catastrophic or just a little unpleasant?

Fixed Rates 

Fixing your rate gives you certainty about what your monthly payments are going to be for a set period. If interest rates rise, your rate won’t, so your monthly payment stays the same. The bad news is they won’t go down if interest rates in general go down.

Fixed rate loans tend to be less flexible. Generally, you can’t make additional payments and you can’t use features like an offset account. Some lenders are now providing flexibility in this area. It pays to check the details.

The big negative comes if you want to repay your loan before the end of the fixed rate period. If you want to repay early you will generally have to pay break costs. These can be very high, especially if interest rates have fallen since you took out your fixed rate.

Break costs are designed to compensate the lender for the losses incurred from letting you out of your loan. If the lender cannot resell the money at the same rate they sold it to you, then you will have to pay the difference in interest rates for the remaining period of your contract.

You’re not betting against the bank

Banks get the money to lend you through a combination of deposits and issuing bonds in the capital markets. They do this over a range of periods. They have standard deposit accounts where the rate they pay is variable and largely in their control subject to the competitive pressures of their peers.

In the bond market, banks can choose to issue short term (bank bills are typically issued for 90 days) or longer term from 1 year up to 10 years or more.

Banks will generally try to match the maturity of their funding to their loan book, meaning they are not exposed to a mismatch in term.

In other words when the bank lends to you at a variable rate, they will fund this with short term money. When they lend to you on a fixed rate for 3 years, they will fund this in the market by issuing 3-year bonds.

So, if you are betting with anyone it’s the market as whole not the individual lender. As markets are in general efficient, it is difficult to reliably outsmart the market.

It’s usually not about saving money

Fixing your interest rate may or may not save you money and it’s pretty hard to get this right ahead of time.

Fixed rates tend to move broadly line with variable rates – in effect the fixed rate is the markets best guess as to what rates will do over the relevant period.

As shown in the graph below, most of the time the variable rate is within 1% of the 3-year fixed rate. This has been the case for 71% of the past 32 years. A 1% difference on the average $650,000 loan would be around $363 a month in repayments.

More importantly it was true 90% of the period up to 2015 until unprecedented activity by central banks caused the fixed rate to decline faster than the variable rate and banks took advantage to use fixed rates as a competitive weapon to deliver lower rates to new borrowers without upsetting existing borrowers.

This golden age for fixed rates seems to be over, as central banks pull back and markets react to increasing inflation and interest rates generally.

But its not so much what the rate is at the time you take out the loan, but what happens to variable rates over the term of your fixed rate period.

Our analysis of what would have happened over the past 30 years when we compared the three-year fixed rate to the average of the variable rate for the 36 months after taking out the loan, shows that if you had fixed your rate, you would have been better off 59% of the time and worse off 41% of the time.

However, the extra cost was generally bigger if you chose to fix.

Beware the bet each way

It can be tempting to seek to have a bet each way – by fixing the rate on half of your loan and leaving the other half variable. This seems like you may be able to achieve the best of both worlds. In practice though you are more likely to end up with the worst of both worlds.

This choice delivers the inflexibility of fixed rates and the uncertainty of variable rates and usually at a higher cost than either. 

It is unlikely that the lender with the most competitive variable rate will also have the most competitive fixed rate. You will therefore be paying more than you need to.

If you need the certainty of a fixed rate, but also want a little flexibility to make additional repayments, then choose fixed with a small portion variable. This will give you the flexibility you need without costing you more.

So how do you decide?

Your choice to fix your rate or leave it variable generally comes down to two things:
  • • The immediate rate difference; and
  • • A trade-off between certainty and flexibility.
Historically, the variable rate has been above the 3-year fixed rate for much of the past 30 years. So, you needed to assess whether a higher rate today was a worthwhile price to pay for flexibility. 

This was particularly so over the past three years where fixed rates were significantly below the variable rate. 

Consumers chose fixed rates in this period in significantly higher proportions than historically as they saw the cashflow benefits and accepted the short-term loss of flexibility as an acceptable trade-off. It is likely that this will return to its more normal percentage as fixed rates rise above variable rates.

Today with fixed rates above the variable rate, you need to assess whether the extra cost of fixing is a worthwhile price to pay for certainty.

Generally, the longer period you choose to fix the higher the rate. So typically, the rate for a 2-year fixed period is higher than 2-years and lower than 3-year or 5-year. 

Right now (June 2022), the range of interest rates generally available are:

1 year
2 years
3 years
4 years
5 years 

These are indicative rates only, and are included to show relativities only. Fees and other conditions may impact the effective rate you pay. You or your broker may be able to negotiate discounts off these rates.

Right now, the premium for long term fixed rates is extraordinarily high, so you need to consider carefully whether this represents value for money. The rates for 1 and 2-year periods seem to provide a better balance between rate and certainty.

Your personal circumstances should be your guide and a good broker can help you make the decision.

Vince Scully

Founder and Chief Sherpa

With over 25 years in Financial Services from consulting to management, Vince Scully is the go-to guy for wealth management and financial advice. Vince founded the Calliva Group; a fund manager, product issuer, advisor and lender to Government and private clients. Vince is an advisor to the Wealth Management Industry, and prior to his role as CEO at Calliva, a senior member of Macquarie bank’s infrastructure team.

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