Fixed Rates vs Variable Rates – Which is Better & How do I Choose ??
The Fixed Rate Cliff
I am sure that most of you reading this will have also read recently about what the media are describing as a “Fixed Rate Mortgage Cliff”.
Well what is it ??
Historically, far more Home Loan borrowers elect to remain on variable rates rather than taking up a fixed rate option. The split between variable and fixed rate loans on any lenders book would historically sit at something close to 70:30.
But between 2019 and 2021, a record number of home loan borrowers elected to fix either part or all of their Home Loans. Most for between 2 and 5 years. This change in borrower behaviour was driven by an ability to avail of fixed interest rates below 2.00%. Hence, by mid-2022 the split between variable and fixed rate loans on a lenders book had flipped to sit at something like 40:60.
Why the cliff then ??
Unfortunately the vast majority of these fixed rates will expire between now and late 2024 seeing roughly 60% of Australia’s mortgage holders facing significant increases to the cost of their Home Loans in a very short span of time.
These same borrowers will then be faced with the decision to re-fix or to allow the loan to go the then applicable variable rate of the day.
So Which Rate Option is Better ??
Without having the benefit of hindsight or that old crystal ball, the answer is almost identical to when the same question was asked before the fixed rates started climbing in late 2021………………..
By that I mean you can’t really answer that one rate option is unequivocally better than the other. Both fixed rates and variable rates have different purposes, they present different benefits and obviously present different risks at the same time.
Whilst fixed rates started climbing in late 2021, the variable rates did follow until the RBA intervened in mid-2022. This ended what was a period of great stability with interest rates that had gone on for some years. But those of us who have been long term borrowers have long known this hasn’t always been the case. Rates have always been able to move up or down, and when they do they often do so in clumps – we’ve seen exactly this lately.
When the Reserve Bank wants to slow the economy, usually to reign in inflation (or slow increases to cost of living), we often see rises in interest rates. It’s a blunt instrument, but effective and almost impossible to get exactly right in terms of how far and how quick.
This is when a variable rate comes with a risk that we will end up paying more interest on the money we’ve already borrowed. In some cases we may be required to increase our loan repayments if the current repayments won’t clear the loan within the agreed term at the new higher rate.
This is where some borrowers enjoy the certainty of a fixed rate. Regardless of any movements to variable rates if your loan has a fixed component the repayments on fixed rate loans won’t move until the fixed rate term expires.
On the flip side………..
The main risks with fixed rates is obvious – that variable rates fall after you’ve fixed. Remember in these instances you have a legal contract with the bank to keep paying the fixed rate that has been contracted for the remainder of the fixed term. You can sometimes break these fixed rates but if you do so you will usually face “fixed rate break costs” and these can be significant.Fixed or Variable – How do I Choose ??
We should start with some pro’s and con’s of each starting with Variable rates…………
Variable rates equals flexibility. Flexibility to make additional repayments whether it be by lump sum
amounts or just simply paying a little bit extra each week on your home loan. Either way it’s going to reduce the loan faster than would normally be the case.
Variable rate loans also offer the flexibility to redraw those additional amounts should the money be required down the track. Rainy day money. The use of an offset account is another obvious benefit of a variable rate loan and offers much the same benefit of redraw.
Now for fixed rates………..
Fixed rates equals certainty. Certainty of affordability and certainty of the interest rate for the term of the fixed rate. Even with higher rates such as we have now, fixed rates continue to be popular with property investors. Why ?? Well property investors fix that part of their income by way of a lease with the tenant. This lease sets out a set amount of rent to be received for a set period of time. These same investors sometimes like to fix their main property cost, being the interest on the loan for, a similar period of time to the lease. It’s kind of like locking in a known profit.
What about rate splits I hear you say ??…………
For the last 5-6 years the most popular choice has been a variable rate and fixed rate split. In my view it has long been the smartest choice available to borrowers as it reduces risk.
Having a split between fixed and variable offers you all the same benefits that we’ve spoken about with the individual variable rates and fixed rates but combining them into one.
When rates are increasing, a rate split would see only the variable component of your loan subject to a rate increase. In other words, you have that fixed rate certainty on the other portion.
On the flip side, when rates decrease, even though you have a fixed portion you still get to participate because the variable rate component of your loan would decrease allowing you to enjoy the benefits of rate reduction.
Even in today’s market there is no such thing as a one size fits all approach to interest rate decisions. You should always avoid the BBQ expert’s opinion and seek the advice of an experienced and qualified finance broker.
Accountplan’s own Mick Doyle has over 35 years in the Australian finance industry and is MFAA accredited. Feel free to call us on 07 3883 8999 and allow Mick to provide you with knowledgeable advice to suit your own circumstances.