It's time to decide! Should I fix my home loan interest rate or should I stay with a variable rate loan?
The short answer is that there is no short answer, so here is the long answer.
Ok, if you have considered fixing your interest rate then now is the time to think about it in a little more detail. Fixed rates are very low historically at the moment and have started to head north over the last month (February - March 2012). At the moment you can usually lock in a fixed rate that is around half a percent lower than the variable rate, so fixing your rate could translate into an immediate reduction in your monthly loan repayment. So fixing is going to save me money, right?
Well sure, in the short term it could well save you some money, but in the long term it could cost you a lot more. People who consider fixing their interest rate usually do it for one of two reasons - the right reason; or the wrong reason. First of all, let's look at the wrong reason.
The Wrong Reason
"I'm going to fix when the rates are low then laugh at everyone on variable rates when they inevitably go up", says the gambler. Trying to predict which way the rates are going to head is a gamble and when gambling, the casino nearly always wins. With home loans, the bank is the casino and they are not going to offer you odds on a bet they think they will lose.
The reality is that regardless of how certain you are that a certain result will eventuate, there is a possibility that it may not. It might be extremely unlikely, but it is definitely possible that Queensland could lose the State of Origin this year. Of course it would probably be the fault of the biased NSW referee, but that doesn't matter - it's the outcome that matters.
So gambling that the rates will go up means that there is at least a small chance that you might be wrong and that the interest rates could actually go down. If you had fixed at the currently available 6.2% for 3 years and contrary to your expectations the variable rates start heading south, you could end up stuck on a higher rate than everyone who stayed on the variable rate. This very thing happened only 12 months ago.
At the beginning of 2011, most people (myself included) were expecting interest rates to go up as the economy recovered from the GFC. They didn't see the so called 'double-dip recession' and the European sovereign debt crises coming and the impact that would have on interest rates. So instead of seeing the variable rate going up by a full percent (100 basis points), we actually saw it drop by 50 basis points. So always remember that your predictions are simply that, and are open to the complete opposite happening.
The Right Reason
"My budget is tight as grocery and petrol prices keep rising, I'm getting less hours at work and if interest rates went up by even a little bit more, I don't think I'll be able to afford to pay all my bills". Sound stressful? Do you think this person is sleeping well at night? My guess is that they would be stressed and quite likely depressed about their financial situation. A possible solution for them would be to fix their interest rate.
I'm not implying that fixing their rate is going to solve all of their problems but it could help them sleep a little bit better at night and postpone a few grey hairs. Knowing that regardless of what happens to the economy, the repayments on their home loan is not going to change during the fixed rate period could provide them with some peace of mind. This is the right reason to fix. These people should be prepared for the variable rate to drop below their fixed rate without it worrying them too much, as the main reason they fixed was so that their rate wouldn't get any higher.
Another reason many people choose to fix their interest rate is if they have investment loans. As the interest payments on an investment loan can be a tax deduction, fixing the rate could allow the investor to more accurately predict the overall costs and performance of the investment so that there are no nasty surprises when it comes to tax time. For one less thing to worry about in regards to the investment property, the investor could be quite comfortable with the possibility that she isn't getting the lowest rate if the variable dropped below her fixed rate.
Things to consider
Flexibility - Usually, fixed rate loans lack flexibility. You can't typically have an offset account attached to them and can't redraw any available funds from them either. This is not often required though as many banks don't even allow you to make extra repayments on a fixed rate loan in the first place. Isn't it crazy? The banks say "Here is $300,000 which we will calculate interest of 6.2% on, but for the next 3 years you are not allowed to pay any more than the minimum monthly repayment". Talk about having you over a barrel! Some banks will allow you to make some extra repayments but only up to a limit - usually about $5,000 per calendar year. (And they can be really dodgy too. I had a client who made the maximum $5,000 extra repayment off their fixed rate loan but still got penalised by the bank because when they calculated the interest the client saved by making that repayment, the total benefit to the client was over $5,000!).
A solution to this problem is to split your loan so that you can fix some of it and leave the rest variable. You can have your offset account attached to the variable portion and make unlimited extra repayments on it without the risk of being penalised. If this sounds like a good idea, just make sure that the amount you keep variable isn't too little that you would pay it off before the fixed portion reached the end of the fixed period.
Early Repayment Fees - If you think you might sell or refinance your property in the near future, it is probably best not to fix. If you do fix and then repay that loan by either selling or refinancing it before the end of the fixed rate period, you could be up for some serious early repayment fees. Let's look at an example:
BDP Bank (Billion Dollar Profits Bank), lends you $300,000 fixed for 3 years at 6.2%. One year later, your dream job becomes available in Perth and you up stumps and put the house on the market. During that year though, the economy has faltered and the RBA has reduced the cash rate to try and stimulate the economy. So now the variable rate is down to 5%. BDP Bank is not happy. They thought they were going to get 6.2% out of you for another 2 years to come, but if you repay the loan they will get their $300,000 back but can only go and lend it out again for the current 5%. How dare you blatantly reduce thier profit margin like that!? It really is very inconsiderate of you - have you no compassion for the poor bank?
Never fear, the bank has come up with a way to make sure you play fair (I mean, the bank always plays fair, right?). They will calculate the profit they thought they were going to make out of you for the remaining two years and will charge you that as an early repayment fee. So the difference between the rate you fixed at and the current variable rate is 1.2% which on $300,000 is $3,600 a year, and with 2 years remaining equals $7,200. This is what the bank will charge you to get out of your fixed rate loan early. Calculations can vary between banks and people have even been penalised when the opposite has been true - your fixed rate is lower than the current variable rate.
So there are lot of things to consider when fixing your home loan. Whatever you do, get some good advice before going ahead and fixing. And by good advice, I do not mean from the bank branch. Historically, people on variable rates have paid less interest than people on fixed rates in Australia, so the banks have a lot to gain from people fixing their rates.
And one last thing. Queensland 3 NSW 0 in 2012.