Newsletter Articles

Interest rates – should you or shouldn’t you fix?

With pressure on inflation and high drama coming out of America’s sub-prime loan market, the hot topic here in Australia is again interest rates. A day doesn’t go by without us having discussions with several customers about the pros and cons of fixed interest rates. “Should we go fixed or variable?” is the question we are regularly asked.

There is no better time than now for customers to talk to us to review their loans, including investigating the pros and cons of fixed versus variable rates. With all the current hype however, we thought it appropriate to use this article to explain to our customers some important considerations which most people probably don’t know.

Firstly, what are the current fixed rates compared to variable rates? A lot of people think that they can simply elect to fix their loan at the same rate that their variable rate is currently at. Not so. In this current market fixed interest rates are substantially higher than variable rates.

Let’s look at a real example for today’s market (January 2008). A customer has a variable rate home loan. The standard variable rate offered by their bank is currently 8.77%. Because the customer’s loan is greater than $250,000 we would have obtained an interest rate discount for our customer of 0.7%, making the customer’s existing variable rate of 8.07%. If the customer wanted to fix their loan for 3 years the Bank’s fixed rate is currently 8.34%. The decision for the customer is “do I lock in now and pay 0.27% more interest than my current variable rate based on the assumption that variable rates will rise by a lot more than this over the next 3 years?”

The graph below illustrates that there have been two (2) increases, each of 0.25%, by the Reserve Bank over the last 12 months (prior to reserve bank announcement on 5th February 2008). With all the effort that the Government has gone to create hysteria by talking-up interest rates in the media many of you would probably have assumed that there were more than two rises last year.

As banks pass this cost on to customers variable rate home loans have therefore gone up by at least 0.50% over the same 12 month period. Fixed interests are however, determined by each Bank’s Economist (not the Reserve Bank) based on their perceived outlook for the years ahead. What a lot of people don’t realise is that fixed rates have increased by at least 1.10% over the same 12 month period.

The other main consideration with fixing rates is the flexibility that you will lose on your loan. Variable rate loan products generally come with benefits such as the ability to make extra payments, offset accounts, lines of credit to draw down on funds for major purchases at a later date, and so on.

Most fixed rates don’t allow extra payments, although there are a few products which will permit clients to pay an additional $5k to $15k per annum but nothing more than that. If you have a healthy disposable income and are keen to accelerate the reduction of a non-deductible home loan debt then fixed rates might not be so good. Similarly, if you were to receive a sizeable lump sum of money (eg. Big commission cheque, work bonus, tax refund, inheritance, or sale of an asset).

There are sizable penalties which banks charge to break out of a fixed rate loan. Some common reasons to break out of a fixed rate include sale of the property, restructuring your loan for tax benefits, refinancing to get a better deal that may become available, and refinancing to use equity for other purchases.

In general, fixed rates provide customers with security in their budget by offering the protection against loan repayments increasing from rate rises. There is a lot of guess-work involved with predicting interest rate movements and it is advisable to make these predictions with the next 2-3 years in mind, not just the next month or 2. It is inevitable that rates will go up and down. The question is when and by how much.

In many cases, 6-Point Finance has recommended that clients structure their loans with a combination of a fixed AND a variable rate product. This ‘cocktail-style’ offers a customer the flexible features which come with variable rates as well as some protection against future rate rises.

Every customer’s circumstances is different. Predictions about your future disposable incomes, property requirements, relocations, employment, etc are just as important as your predictions about interest rate movements. We invite all customers to contact your 6-Point Finance consultant to discuss your circumstances with a view to helping you make a balanced decision.