The Great Interest Rate Gamble!

Introduction

Fixed or Variable?

The big choice you're asked to make when taking a loan. The topic of Sunday BBQ discussions and advice sessions from your parents - a polarizing matter where ordinary citizens suddenly become experts on all things economics and world politics. No-one wants to be wrong, right? No-one wants to pay more, right? And everyone wants to "back the right horse," right?

 Hi, I'm Jordan from Mountway. I've been a broker and commercial banker for over 15 years, and as a home and business owner myself, I know how stressful it can be to make the right choice for any kind of loan, especially something as important as a mortgage.

To help you make an informed decision, I'll be breaking down the difference between variable and fixed interest rates and some common reasons why you might choose one or the other when seeking a home loan.

So, to start, what do either of these terms actually mean?

Put simply, a Variable Interest Rate means your mortgage payments will increase or decrease in response to changes in the Reserve Bank's official cash rate. As interest rates go up or down, your payments will too.

With a Fixed Interest Rate, you can lock in a set rate for a fixed period of time, so your mortgage payments remain consistent no matter what’s happening in the economy. Let’s dig into this one a little deeper. 

All about Variable Rates

It might come as some surprise that while you are borrowing money from your bank, it is in fact borrowing that money from other sources in order to fund your loan. A major source of funding for Australian Banks is the Reserve Bank of Australia. 

Every month the Reserve Bank decides whether to increase, decrease or keep steady its cash rate, which is the price it charges your bank for loans made to it. If you have a variable loan then, usually, your bank will pass on some or all of that increase or decrease in cost from the Reserve Bank.

As a result, a variable rate loan will generally move in sync with the Reserve Bank cash rate, but there are many exceptions. 

Banks are at liberty to set their variable rates in any way they deem appropriate and at any at time. In practice any change in your variable interest rate which is out of sync with the cash rate is driven by business requirements (read into that to mean their need to make a profit) and competition. For example, if a bank is feeling like it has enough home loans on its books and therefore is not needing to compete hard, it may increase its rates by more than what the cash rate has increased, or it might increase rates even when the cash rate has remained steady. Many banks notoriously undertook this practice during the global finance crisis in 2008. 

So the primary drawback of a variable interest rate is uncertainty. Since your repayments can fluctuate, it can be challenging to budget accurately over the long term. Variable rates can both decrease or increase, but increases will leave you with higher mortgage repayments and increased financial strain. Even worse, depending how you are wired, copping a higher rate can leave you envious and resentful of your smug friend who proudly boasts of the hot low fixed rate they secured right before the Reserve Bank started hiking the cash rate….

But for the cost of that uncertainty, you do acquire two major benefits - flexibility and offset.

Flexibility means being able to do anything with your loan, or indeed your property, at any time.

If your lender turns out to have awful customer service, you can easily refinance.

If your lender is hiking its variable rates but another lender is still offering sharp rates… refinance.

If you want to renovate, or your working situation changes, or you want to change anything to do with your loan approval such as moving onto interest only payments, a variable rate means you can approach any lender to get it done rather than be stuck with the one you have.

And if you spot an opportunity to sell for profit or cash out for a dream property, you can sell the property, and repay the debt with no penalty.

On top of all of that, if you’re diligent and tucking away more each month than the minimum requirement repayment, then on many variable loans those surplus funds can go into offset, where they’ll reduce your interest cost and in many cases, take years off your loan.

All about Fixed Rates

So, Fixed Rates… this is where you set a rate with your lender, typically for a period of 1 to 5 years, and that rate is contracted to stay the same for the fixed term, regardless of changes in the cash rate, or competitive pressures on your bank, or their business strategy. 

This makes predictability one of the main benefits of a fixed interest rate, as you can budget more effectively when you know exactly how much you'll need to repay each month over the fixed period.

This can be especially helpful for first-time homebuyers, anyone on a tight budget, or those with a fixed income. It is also recommended for people who are risk averse generally or who have only a thin financial buffer (also known as a rainy day fund) to deal with unforeseen financial pressures. Finally, many investors find fixed rates attractive for various reasons I will cover in another video.

However, like everything, there are also some downsides to choosing a fixed interest rate.

First, often you'll likely find that fixed interest rates start higher than variable rates as you pay a premium for the added stability. 

Also, if the general consensus in the economy is that the Reserve Bank is in a cycle or increasing its cash rate, the fixed rates on offer reflect this expectation. If you take a 2 year fixed rate, your rate reflects where the banking market expects the cash rate to land, on average, over the next 2 years. 

In practice what this means is that many people will opt for fixed rates when they feel a little threatened about the immediate future of the economy. The problem is that if you are feeling threatened, the banking market has most certainly already read the economy and has considered a rising cash rate to be very likely. Therefore the fixed rates on offer will already be well above the current variable rates. Unfortunately many people fix their rates after the news of rising cash rates is out of the bag, and they end up fixing in at a level well above what they would pay if they were on a variable rate.

If you’re on a variable rate you can in fact absorb rate hikes much higher than the fixed rates on offer and still come out with the same overall interest rate cost over the fixed rate period. That is, the average of a rising variable rate might in fact be the same or lower than the fixed rates on offer.

Fixed rates are therefore not a guarantee that you’ll pay less.

But by far the biggest drawback to fixed rates is inflexibility, which comes in the form of:

1. Limited or no access to interest offset features on your loan, meaning you have no mechanism to reduce your interest cost if you are making more than the minimum repayment, and
2. Having to pay a break fee if, for whatever reason, you need to repay early, vary or cancel your loan during the fixed period.

So….If your lender turns out to have awful customer service, you can refinance, but at the cost of the break fee.

If you want to renovate, or your working situation changes, or you want to change anything to do with your loan approval such as moving onto interest only payments, you can but at the cost of the break fee.

Unfortunately “a change in circumstances” can even mean divorce which leads to the forced sale of an asset - the break fee that applies is like insult to injury.

That fee differs between banks and is often influenced by the time left on the fixed term, and the way variable rates have moved after you have fixed your loan.

The best situation for reducing your break fee is to wait until very late in your fixed term, or when variable rates haven’t changed much since you locked in.

Choosing Between Fixed and Variable Rates

If your head is spinning with all of the considerations please know that this is natural! 

How the heck is a humble little home owner or business owner supposed to be across the banking market’s expectation of future cash rate movements, and how the heck are you supposed to know whether you’ll need to refinance, restructure or otherwise change your loan in the next 1 to 5 years?!

When deciding between fixed and variable interest rates for your home loan, it's essential to weigh up your individual circumstances, risk tolerance, and long-term financial goals. 

Wow that sounds so generic but hear me out!

Like it or not, you gamble whether you take a variable rate or a fixed rate.

With a variable rate, you are gambling that interest rates will not increase, and for the risk associated with that gamble, your reward is being able to participate in interest rate decreases. 

All of that is taken off the table with a fixed rate - no upside or downside. But you are still gambling, because you’re betting on rates going up and are therefore buying your protection from that.

DON’T GET HUNG UP ON TRYING TO KNOW WHICH WAY RATES WILL GO. 

That’s your ego speaking, and be it known that hundreds of prominent economists on TV and working within banks are frequently wrong about their predictions on the future of interest rates - sometimes massively…..

The decision to go fixed or variable should rather be based on whether you can tolerate the particular pros and cons that potentially come with each choice.

If you choose variable:

• Do you have buffer in your budget
• Do you have a rainy day fund
• And is the risk of rising costs and your own anxiety worth the benefit of offsetting interest and being able to change your lending arrangements easily and with little cost

If you choose fixed:

• Are you comfortable with this asset and with this loan for next 1 - 5 years
• Can you accept that you may actually pay more interest over the life of the fixed loan than if you stayed on variable
• And is the comfort of this stability worth more to you than the increased cost that comes with break fees and being unable to offset interest

Which Loan is Better?

I hope my rant demonstrates that there isn’t an answer to that question which is true for everybody. 

And besides, there are ways to hedge your bets, if you like. It is possible with many lenders to split your loan up into several parts, including a variable component and components allocated as 1, 2, 3, and 5 year fixed. That would essentially play the field!

And a really important consideration to layer over this structure is that your cheapest bank isn’t usually cheapest in all categories. The best variable rate lender may in fact be pretty poor with their fixed rates. And what about the best fixed rate? When that rate expires, is your bank competitive on their variable rate?

This is where we do our best work. We’re not mortgage brokers we’re lending advisors. How you structure your loan and the peace of mind you get from considering these angles are just as important as getting the approval, which incidentally, we consider ourselves to be rockstars at also.

“Tell me more” is one our favourite questions as it helps us understand much more about your “individual circumstances, risk tolerance, and long-term financial goals” so we can get this stuff right and deliver your bespoke loan….. Not so boring and generic now right?