Fixed Interest Rates

To fix - or not to fix - that is the question

THE SHORT ANSWER

Let’s get the punchline out of the way 1st so that – if you just want a quick read or quick guidance - you can get on with your day (but please review the General Advice Warning as well).

We will never advise you whether you should or shouldn’t fix a rate – mainly because our crystal ball is broken and has not yet come back from the repair shop.

What we will do is educate you about the genuine factors you should take into consideration – and try to protect you from incorrect considerations, urban myths, and commission-fuelled salespeople.

In short (here’s the punchline) we recommend you consider the following list.  For more detail on why, how fixed rates are calculated, limitations etc – there is greater detail below:

  • NEVER fix a rate because you think you’re going to beat the Bank – its madness;

  • MOST PEOPLE fix their home loan at precisely the wrong time for precisely the wrong reason;

  • BE AWARE of the many limitations that come along with fixed rates;

  • BE AWARE that Lenders use fixed rates as the only real ‘handcuffs’ they have left to ‘trap’ or penalise Borrowers;

  • ACCEPT that you will most likely pay a premium (i.e. more) for a fixed rate over time than if you stayed on variable rates;

  • ONLY fix rates in order to obtain certainty of payment for a finite period; and

  • BE CONSCIOUS of the variable interest rate environment during your fixed rate period.


PUTTING THE MEAT ON THE BONES


Should I fix my rate?  When should I fix my rate?

If you were to ask, for example, Scott Pape (The Barefoot Investor) when you should fix your home loan the answer would almost certainly be, “NEVER!!”.  Scott likes to deal in black and white statements and keep things really simple (and marketable) - but the real world is full of grey and nothing is ever that simple. 

So, we think “never” is too simple a statement and, like almost any simple yes or no answer, can often be the most misleading thing that can be said.

If you ask a lot of Mortgage Brokers – or people at a barbecue – or your broke Uncle (not sure why but he seems to be a source of trusted financial advice in Australia) – you would undoubtedly be told, “When fixed rates are cheaper”.

‘Cheaper’ is a very interesting term to be applied to the comparison between a fixed rate and a variable rate.  Yet – it is one of the most common questions we get, i.e. “Are fixed rates or variable rates going to work out cheaper for me?”. 

Whether a particular fixed rate, or variable rate, is ‘cheaper’ than the other is also one of the most common statements made by people “selling” home loans (think Bank employee or commission-based mortgage broker).

Respectfully, this is the intellectual equivalent of asking whether an apple or an orange is a better piece of fruit.  My answer will depend on many factors – including what are your plans for that piece of fruit?  If you want to make an apple pie – the answer is pretty simple.

But if I don’t ask you that one simple question – or I make a recommendation in the absence of that knowledge – then I may recommend an orange because I have a natural bias towards fruits rich in Vitamin C (or I can sell the orange more easily because I know that your broke Uncle told you it’s the best fruit ever – or someone just wrote a best-selling book or ‘viral’ blog about oranges).

The serious point here is that the only way the price comparison question can be answered is at the end of the fixed rate period when you can look back and see what variable rates (from that specific Lender) have done compared to the rate you fixed in at.

The other thing you need to understand is how Lenders set their fixed rates.


How do Lenders calculate a fixed Rate?


We’re going to keep this as simple as possible.  There are a lot more market considerations (and mechanics) to this – so if you are deeply analytical, or you work ‘in the markets’, please do your best not to throw stones at us.

The Lender will have in their employ (or at their disposal) a Team of economists, market analysts etc whose job it is to determine what they think variable rates will do over the period of the fixed rate. 

So, the 1st takeaway is that you are up against a Team of tertiary qualified specialists who do this all day – every day.  The notion that you will outsmart them in your spare time is questionable (and even if you do – read the last part of this Section and the bit about ‘Rate Lock Fees’).

The Bank then averages their predictions of variable rate movements and come up with a number.  That number then has a ‘risk margin’ added to it to arrive at the fixed rate. 

The risk margin is the Bank’s insurance policy in case they’ve got it wrong a bit.

So, the 2nd takeaway is that you are basically being asked to carry the risk in case the experts have it wrong.

The 3rd takeaway is that, assuming the experts have got it about right, you will pay a premium to have a fixed rate.  Unless some very unpredictable things happen to our economy, it shouldn’t turn out to be a large premium – but you should very definitely accept that you’ll be paying a premium.

The 4th takeaway is that if prevailing fixed rates are lower (as some like to say – ‘cheaper’) than variable rates this just means that the Banks are very confident that, on average, variable rates are headed downwards during the fixed rate period.

Oh – and by the way, you don’t get the fixed rate that is on offer on the day you make the decision – or even on the day you make a full loan application – or even when that application is approved – unless the Lender offers a Rate Lock Feature (which in most cases you pay extra for).

You get the fixed rate that the Bank is offering on the day your loan settles.  So, in the absence of a rate lock feature, if something major happens the day before settlement (or a week or two before if you’re not paying attention) its too late to do anything about it and your fixed rate could be significantly higher than what you bargained for.


Rate Lock Fees


Assume for a moment that you pick a market trend, or economic upheaval, before the Bank’s experts do.  For well-informed and analytical people this is a very real possibility.  But you won’t be all that far ahead (as a rule).

So, as explained above, the Banks effectively also ask you to carry this risk (i.e. the risk that you’re a bit smarter or a bit quicker on the uptake) by having a loan contract that allows them to change your fixed rate up until the day of settlement – unless you ‘invoke’ a rate lock feature.

Whether specific Lenders offer this Feature, how ‘generous’ it is, and how much you will pay, varies greatly between Lenders and is outside the scope of this Fact Sheet.  But it should very definitely be a part of your research if you do want a fixed rate.


Limitations


With very few exceptions fixed rate loans have the following limitations:

  • They don’t offer 100% offset accounts or redraw facilities;

  • They don’t allow, or significantly limit the amount of, additional repayments you can make during the fixed period (without incurring a break fee);

  • We can very often negotiate considerable discounts on variable rates - over and above the Lenders advertised 'specials' - but the opportunity to do so on fixed rates is very restricted (and often not possible at all);

  • The revert rate (the variable rate you get at the end of the fixed rate period) is very often significantly higher than the discounted variable rate available from that same Lender on ostensibly the same product.  This is basically legalised “bait & switch”.  It may be a long con – but Banks know that about 80% of people fail to refinance for several years even after they know they’re on a bad deal; and

  • If you choose to refinance during the fixed period (even internally with the same Lender) you will pay a break fee (see ‘Break Fee’ Section below).

There are fixed rate Products that offer greater flexibility (they are few and far between – but they exist).  However, fixed rate Products that offer greater flexibility, or ‘fairer’ revert rates, are almost always not the most competitive fixed rates.

At the end of the day – fixed rates are largely the “shiny object” that the Banks hope you will swallow whole.

You can get some of the benefits of a fixed rate with some of the flexibility of a variable rate by using a ‘Split Loan’.


Split Loans

A Split Loan (in this context) is where you take part of the loan facility as a fixed rate and part as a variable rate.

If you are considering a fixed rate loan but you want the flexibility of an offset account or a redraw then the simple rule of thumb is to have a variable portion that is at least equivalent to the maximum amount you expect to hold in your offset or make as additional repayments during the fixed period.

Quick examples using a 3-year fixed loan:

  • If you think you can save (or make additional repayments of) $50K a year – then the variable Split needs to be at least $150K; or

  • If you are expecting a lump sum (inheritance, compensation etc) of $200K during the fixed rate period – then the variable Split needs to be $200K plus any additional savings or repayments you expect (so using the savings figure from the previous point - the total of the variable Split would be $350K).


Break fees

These are also known as economic cost (or loss) fees.

The amount of a break fee can’t be calculated until you ‘break’ the loan.

Some of the Bank formulae for calculating the break fee are little better than ‘black magic’.  But simplistically, the break fee will almost always erode any benefit you get from refinancing. 

For example, let’s assume you wake up one day and the fixed rate you took (because it was ‘cheaper’) is now quite a bit higher than the most competitive variable rates.  So, you decide to refinance (the salespeople will be only too happy to help).

But your current Lender is going to look at their economic loss – that is, the difference between what you’re paying now on the fixed rate and what you will pay on the variable rate – and they will charge you a break fee that constitutes the difference for the remaining term of the fixed period.  They’ll then tack on some other fees for good measure – sprinkle it with a bit of fairy dust - and do their best to hide it all in one single ‘loan payout figure’.

Now, the salespeople will tell you not to worry about the break fee because they’ll just add it to the new loan – and anyway “look at this nice new low variable rate” (‘shiny object’).  It’s even more sinister when it’s the same salesperson that sold you the shiny object fixed rate in the first place and who you are loyal to because they’re such a nice person and help you get a ‘cheaper rate’ every couple of years. 

So – let’s be really clear about what’s happening here:

  • All of the benefit of the refinance (and then some) is going to the outgoing Lender and not into your back pocket;

  • You are paying forward interest to the outgoing Lender on a loan that you don’t even have any more;

  • You are paying additional interest on the extra money you borrowed to pay the break fee; and

  • The salespeople have pocketed another upfront commission or employee bonus

Bottom line – Beware - it’s a trap set for people who think they can beat the Banks.  And it's the last legal trap the Banks have left now that 'exit fees' and 'deferred establishment fees' have been banned.


Most people choose (or are sold) a fixed rate for the wrong reason at the wrong time

By now you’d understand that the ‘wrong reason’ means trying to beat the banks.

Following on from the previous point, and ‘How fixed rates are calculated’, the wrong time means almost all Australians who fix their rate do so either:

  • When the advertised fixed rates are lower than prevailing variable rates meaning that the smart money says rates, on average, are going down; and/or

  • When the headlines, blogs (or your broke Uncle) announce that you should fix rates (just very uninformed herd mentality that will let the salespeople eat you alive); and/or

  • When the headlines, blogs etc announce that rates are on the way up – so you should get in quick and fix your rate (too late – refer to ‘How fixed rates are calculated’ and ‘Rate lock’)


The end of a fixed rate period


While this point is not actually a consideration of whether you should fix your rate or not – it is something that we believe is not discussed enough.

If you do choose to fix your rate remember that, unlike in some other countries, we tend to have relatively short fixed rate periods and by far and away the most common period is 3 years.

It is a very good idea to keep your eye on what variable rates are doing and, if you believe the variable rate you will come off into will cause you financial stress – make a plan before you get to the end of your fixed rate.  Remember check your revert rate and not the Lender’s heavily discounted variable rate for new business only.

Even if you think any increases to variable rates won’t cause you undue stress, remember that when you’re on a variable rate you adjust to each rate rise when it happens.  Whereas, at the end of a fixed rate period it is possible for you to revert to a variable rate that is a few percent higher than what you’ve been paying.


So – when are fixed rates a good idea?


By now you may be thinking, “Hey, you said you didn’t say ‘Never’ to fixed rates.  Sounds to me like you hate the things and you are saying ‘Never’.”

To be clear – we are neither for or against fixed rates. 

We are for understanding, and taking into consideration, all the above information. 

We’re against making uninformed decisions that more than likely will work against you.

But fixed rates do have their place – and the following is, in our opinion, the one and only place they have.

You should consider fixed rates when (and only when) certainty of repayment is important to support your goals and objectives and you are happy that you will most likely pay a premium for that certainty. 

Think of it like paying an insurance policy on your home.  You hope that your house won’t burn down – but if it does you are at least comforted by being able to rebuild.

Even if you have a fixed rate, you hope variable rates won’t go through the roof (see ‘The end of a fixed rate period’) but you are at least comforted by being sheltered temporarily and having time to plan for when you go back onto variable rates.

Some examples of when certainty of repayment might be important are:

  • For investors – being able to match your outgoing cash flow to your rental income might be important to you, especially if you have multiple investment properties. 

  • You need to be sheltered from market volatility during the fixed rate period – e.g. you are about to have a family, or another child, and one of the bread-winners will be taking some time off work.  A fixed rate will mean that any significant variable rate increases during that period won’t cause financial stress or force you to go back to full time work before you really want to.

Editor’s Note.  When I had many investment properties on the go, I almost always fixed at least some of the loans for 5 years – despite 5-year fixed rates being quite a bit higher than prevailing variable rates.  If you refer to the ‘How do Lenders calculate fixed rates’ Section, you should understand why I was OK with this - and why it quite often worked out well as variable rates increased and overtook my fixed rate.


How long should I fix my rate for?


Just like everything else we’ve discussed – choosing the term of your fixed rate should not ultimately be about ‘cheaper’.  You need to match the fixed rate period to your goals and objectives.  If you need certainty of repayment for 5 years – then that’s how long you need to fix, even if 2-year fixed rates are lower.

And, if you need 5 years, don’t even contemplate fixing for 2 or 3 years and then assuming (hoping) you’ll find another low cost 2-year fixed rate.  If variable rates have gone up in the meantime, you’ll be stuck.

Because we’re realists – and assuming you’ve read this far – if we haven’t managed to dissuade you from choosing fixed rates just from a ‘low cost’ perspective then here’s what you need to know:

  • Historically, 3-year fixed rates have tended to be the ‘best value’ because this is where most Lenders compete most aggressively in the marketplace and therefore this is where they have ‘shaved’ their risk margins the most (we would say in some cases removed the risk margin altogether).


Expect to Refinance

Finally, regardless of your reason for selecting a fixed rate, you should plan to refinance at the end of the fixed period (or at least carefully review your position) because you will almost certainly come off into an uncompetitive variable rate as mentioned previously.

Get this review underway about 8 weeks before the end of your fixed period so that, if required, you can have the refinance settled essentially the day after you exit the fixed rate.


Conclusion

By now you can probably understand why Scott Pape keeps it simple and says “Never” – but we hope this broader treatment of the subject assists with your understanding of why.

We also hope that you understand why we won’t advise you whether you should or shouldn’t fix your rate. 

It’s just not as simple as other people (and home loan salespeople) want you to think it is – especially given that any of the genuine reasons to fix rates are deeply personal.

And, of course, we live in the 2nd most litigious country in the world with arguably the most one-sided Consumer Law in the world – so we’re not putting our heads on that chopping block thanks all the same 😊.


Next Step


If you’re not already a Client, please feel free to Contact Us if you want to access independent and unbiased mortgage advice and – whether for a variable rate loan, split loan, or fixed loan – we will assist you to genuinely lower the cost of your home loan.


GENERAL ADVICE WARNING

If you have been directed to this Fact Sheet by your Independent Mortgage Planner it is in order to allow you to review some relatively detailed considerations in your own time and at your own pace.  Only any specific advice subsequently, or previously, provided by your Independent Mortgage Planners constitutes personal advice.  In all other circumstances, the information provided in this Fact Sheet is general in nature only and does not constitute personal advice. The information has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any information in this Fact Sheet you should consider the appropriateness of the information having regard to your objectives, financial situation and needs. Before making any decision, it is important for you to consider these matters and to speak to an Independent Mortgage Planner.  We provide Credit Advice only.  You may also wish to seek appropriate legal, tax, and other professional advice.

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