With fixed rates tumbling to all-time lows, you may be thinking of taking the fixed option. Michael Lee looks at the important issues you need to consider before making the move
A couple of months back, you may have read my finance hacks and tips list with its number one tip of “fix your exposure”. It wasn’t a direct instruction, but it did spark quite a few questions from readers. This was partly because it was a light treatment of an important decision, but also, by the time the article hit news stands, banks had pushed the marketing button on a somewhat overhyped ‘rate war’!
So, just quickly, in case you missed it, the ‘war’ started with the Commonwealth Bank launching the first salvo by dropping its five-year fixed rate to 4.99%. The others, including NAB, which broke up with the other three a few years ago, appear to have reconciled, getting together and toeing the line to match CBA. And that was about it. More of a playground scuffle between a group of mates than a rate war.
Of course, getting the rate under 5% was a nifty trick, but if you’ve shopped your deal well, you’re 1–2% below 5% already on rate, and even more so if we're talking about effective rate. This is a timely reminder of some important points:
Are interest rates set to rise?
- Lenders are hungry, but if you show your hand they will take the soft, price-match option. So you’ll wind up with something that’s only slightly better, if at all, and it will be a far cry from what you could get if your deal was negotiated properly.
- The banks (and a good swag of brokers) are more interested in marketing fixed rate loans because they often have heinous early-exit fees that lock you in. This enables them guaranteed profits and commissions, making it easier for them to plan ahead for the next few Christmas parties.
- Rate is a simple sales headline that doesn’t always have as big an impact on your Total Individual Cost as you might think.
- The discounts to the fixed rates at the retail end were sudden and substantial, exceeding any recent reduction in funding costs. So the reality is there’s plenty of fat there; the banks and their supporters just don’t like talking about it, although the CBA’s $8.6bn profit is a bit of a dead giveaway.
Yes, definitely – one day. They could fall too. OK, I get that’s not the answer you are looking for, but these are the bare-bones facts and we’ll discuss how you should react to that in a minute. But before we go there, let’s take a look at two things that have a big influence on what happens with interest rates.
The first is funding cost; that is, how much it costs lenders to obtain the money they then lend you. While there are a bunch of ways different lenders raise money, one central, albeit rather simplified indicator is the RBA’s cash rate target (the cash rate).
A little economy lesson
Before I go any further, I apologise to the economists. This is not a doctorate for my PhD, just a basic thumbnail sketch of how it all works.
For the most part, the cash rate is set based on the RBA’s outlook on the state of the economy. The lower the cash rate, the more the RBA thinks the economy is struggling. Lower rates mean cheaper money; cheaper money means people and businesses borrow more.
When we borrow more, we buy more stuff, and that means the economy works harder to make, buy, distribute and sell that stuff. Well, that’s roughly the theory anyway. At the moment, talk on the cash rate is quite solid that the next move is up. Nobody is sure whether that’s true, and few are calling for a rate rise to happen in the next year or so.
So why is that important to you? If you go back to August 1990, the cash rate – which indicates how much the banks’ money costs them – was around 14%, which they marked up and sold to you at 16.5% on your mortgage. That means banks were spending 14% buying their money, to make 2.5% from you. In other words, they marked up prices by less than a fifth.
Blast forward to the present day and the cash rate is 2.5%, so the banks’ money is now costing lenders around 2.5% but they’re adding 2.65% to your interest bill as their cut, which means they are now marking up by more than 100%.
Now, if banks were still marking up their prices like they were in 1990, you’d be paying 3% on your mortgage, but I don’t think there are many Aussies out there that are. Put simply, you’ve gone backwards.
However, that also means that when you remove the spin there is plenty of margin for banks, brokers and non-bank lenders to deliver better mortgages that cost you less. With mortgage contests starting to get a foothold, independent mortgage advisors appearing around the country, and some big players poised to enter the market (think Coles and Woolies), it’s quite possible the margin pressure will get the rate you pay closer to the cash rate. It’s optimistic to think we can get back to 1990 margins, but never say never.
So should you fix or stay variable?
Anyhow, enough about them. Let’s talk about you and more about whether you should or shouldn’t fi x your rate. If you’ve read my book, Mortgage Free, Debt Free, or you read Your Mortgage magazine a few years back, you’re bound to have the odd fl ash of déjà vu, but it never hurts to refresh.
So back to basics … Removing uncertainty is what fixed rates are all about – locking in your interest rate and locking in your loan repayments for a certain period of time.
Generally speaking, while you remove uncertainty, locking in will cost you in three ways: you lock in a higher rate than the variable rate you could have today; you lock into early-exit fees which can be massive and strike you if you break your fixed rate; and extra payments, redraw and offset are non-existent. Of course, as your debt is tax deductible, the latter is probably far less important, but you never know.
Now, because variable rates can’t have early-exit fees but fixed rates can, it’s harder than ever before to get impartial advice on whether you should fix some or all of your loan. Like every decision, there will always be opinions for and against. Listen to each argument and you will probably hear compelling and justifiable reasons based on statistics, economic trends, savings, and dollars and cents, but what does that really mean to you? Should you think about taking a fixed rate mortgage over variable? Yes, always. But that doesn’t mean you should actually do it.
Like many Australians, I am a big fan of variable rates. For most of my property investment life, which now spans 24 years (just where did that time go?), I have only ever had variable rate mortgages. That is, except for one brief stint a few years ago when I switched a couple of my investment loans to fixed rate.
But again, does that mean you should too? The short answer is a definite maybe, which is about as useful as a dust bowl in the middle of the desert. But don’t flip the page just yet. By the time you finish reading this article, you should have a better understanding of the significance of your decision and a much clearer answer based on your needs, which is what this should be all about – you.
Let’s talk about risk
Risk is the chance of an event happening. Impact is the result of that event occurring. Although risk and impact go hand in hand when you make a decision, they each have a greater or lesser ability to affect your decision, depending on your own personal attitudes and what is at stake. Regardless of whether you choose to acknowledge it, risk and impact are present in every decision you make.
In the case of your mortgage and its rate type, you have a simple decision: either you fi x your interest rate, or you do not. If you don’t fi x, your interest rate will be variable, which is to say your lender can change it either up or down, by as much as they like, any day of the week, and therein lies the risk of taking a variable rate mortgage.
So the sixty-four-dollar questions are: will they and, if so, by how much? But I’ve already answered that one for you, right? Nobody knows. Although some punters are happy to take a guess to get a headline, you should remember that it’s just a guess.
The risk and impact of going variable
If your properties are geared, the daily interest rate directly affects your ROI and in extreme cases your ability to even hold that asset.
Assuming you have a reasonably reliable, steady income for yourself and from your investment properties, loan repayments may still also have a significant impact on your ability to live a happy life. A low repayment gives you more money to live the way you want to and do the things you need to (‘disposable income’ in economic terms); and, sensibly enough, a higher repayment creates restrictions on how you live. By taking a variable rate mortgage, you will relinquish a little or a lot of the control you have over your ability to live a happy life or, at the very least, have a confident view of your ROI.
In the year between October 2009 and November 2010, interest rates on competitive variable rate mortgages rose by around 2% per annum. Many experts would have considered that increase unlikely and assessed the risk of it actually happening as low. No matter whether you assessed the risk, the fact of the matter is it happened.
During this period, some people raced to fix, others were able to ride it out, and many lost their homes or other properties. Some are still struggling. Each of these people experienced a different impact, and that impact was a lot worse for some than it was for others.
Although an increase of 2% per annum may not sound like much, it is very sharp when you put it in perspective. So let’s try.
If you close this magazine now and shop your deal right, you should have no trouble finding a variable rate mortgage with an effective rate of between 4.5% and 4.99%, even with three of the ‘big four’. And if the interest rate cycle from October 2009 repeated itself, the impact for you could be worked out using this formula:
Total rate increase / current rate x 100 = increased interest cost or 2% / 4.5% = 44.45%
This means that, in simple terms, your interest costs would jump by almost 45% in 12 months.
As a borrower this 45% increase would cause an impact ranging from barely noticeable to losing the farm, so it is important to individually consider how this would affect you. If you are more up the ‘barely noticeable’ end of the spectrum, you can probably relax. If not, you really need to do some serious thinking about the risk.
So what is the risk of it happening again?
As uncomfortable as it may be to read, nobody really knows. However, it is fair to say the risk is harder to gauge today than it was 15 years ago, for a number of reasons.
Not so long ago, the interest rate on a variable rate mortgage moved in line with the state of the economy. When the economy was booming, wages would go up, jobs would go up and so would the interest rate on your variable mortgage. That made it somewhat predictable and meant the historical risk of a variable rate was relatively low, especially if you were borrowing within your limits.
Much of this predictability came from the capacity of the RBA, with help from the government and also market competition, to indirectly control the interest rate that lenders charged you on your mortgage. When the RBA increased the target cash rate by 0.25%, lenders increased your mortgage interest rate by the same amount. When the RBA reduced it, lenders also reduced it by the same amount, and of course when the RBA left rates unchanged, so too did the lenders.
However, in October 2007, Bankwest, now owned by the Commonwealth Bank, broke ranks and started moving their interest rates up, independent of the RBA.
What started out as an unnoticed blip quickly became common practice for many lenders. ANZ was the first of the big four to try it; the Commonwealth Bank following not long after. Each of the majors did it a second time and discovered that, although they got a bit of bad press, borrowers continued to flock to them and they still made gargantuan profits. So they did it again.
Since that time, a bunch of things have happened to empower lenders, in particular the big four, to drive interest rates up on variable rate mortgages. It is important to understand that this is despite RBA signals that in the past would have reduced or held interest rates steady.
So now, in addition to the historical triggers that affect rate movements, you have a newly executed practice of lenders striving to outprofit each other by moving independently of the RBA. The implication for your risk is that even when the economy is steady to floundering and the RBA suggests rates are on hold or may even fall down (for example, now), lenders may act differently.
All of this goes part of the way towards explaining why banks have been able to create mega profits by increasing their margins while they control the game through size, scale and a lack of borrower access to impartial information and bargaining support.
However, it is not all on the downside for the variable rate mortgage. Provided you are able to handle the risk and impact of rate increases, you will generally gain powerful benefit from a lower daily interest rate (although this is definitely not always the case), more flexible offset options, and, most importantly, a less costly option to vote with your feet when your lender lets you down and as competitive tension picks up.
The cost of going fixed
The main reason for taking a fixed rate mortgage is that it eliminates all the risk that comes with a variable rate mortgage, offering you a fixed repayment amount, with a known interest cost for a definite period of time.
This means there is simply no way you will lose the farm or be arguing over money because of interest rate movements on your home loan during the fixed rate period, because, quite simply, the rate, repayments and costs do not change. However, that protection is usually not free.
Generally speaking, fixed rate home loans will cost you anywhere between a little and a lot more than their variable rate mates. If you didn’t close the magazine to find a competitive variable rate a little earlier, then thank you for ignoring me on that idea.
However, if you close it now you may still find fixed rate loans with an effective fixed-term rate of around the 4.75% to 4.99% mark, although it’s odds-on that fixed rates will have changed, at least a little, between the time I wrote this article and the time you are reading it. Importantly, an ‘effective fixed-term rate’ is the effective rate for the actual fixed term, not the life-of-loan comparison rate that lenders quote, which skews results. So, at this frozen moment in time, the cost of fixing is somewhere in the range of around 0.2%– 0.5% per annum. If rates fall it winds up costing you more, and if rates rise it winds up costing you less – and who knows, it may even wind up saving you some interest.
The closer fixed rates and variable rates are to each other, the more lenders believe that interest rates will remain steady or fall during the fixed rate period. However, bankers get it wrong too.
Now, if you are thinking about fixing, saving interest should be the last thing on your mind. That is not what it’s about, and people who focus on this aspect miss the point. A fixed rate mortgage is an insurance policy against financial pressure brought on by mortgage rate movements, especially rapid ones that could cost you the farm.
In the last 15 years there have been two periods of sharp rate increases. The recent one kicked off in October 2009 and another in August 2007. There have also been two periods of moderate increases, starting in November 1999 and again in May 2006. So again, the point is, it does happen and you should think through your position carefully before deciding what is right for you.
When is the right time to fix?
Even though we’re talking about investment loans, your mortgage is a very large financial obligation. For most people, it is the largest and most costly financial decision of their life. Careful consideration and regular reviews are critical components of getting the most from your mortgage and making sure it works for you, not against you.
At each review, you should ask yourself whether the loan and structure you have is working for you, whether you have achieved your financial objectives, and how you can improve on those objectives.
While there is never an absolutely right time to fix your loan, it is one aspect to consider at each review milestone you set for yourself. Ideally, these should be every three months or so for variable rate loans, and three months before the expiry of any fixed rate loan. This doesn’t mean you should change lenders every three months; in fact you should plan to be with a lender for at least three to five years.
A final thought: beware the 50/50 con
If you’re ever advised to take part fixed, part variable, and you’re not already firmly committed to taking mostly fixed, challenge your advisor or run screaming. Part fixed, part variable in itself is a valuable approach for some people who want full offset flexibility with fixed rate security; however, the default notion of splitting 50/50 stacks the odds against you.
Fixed rate tip
When you compare fixed rates, put aside the full-term comparison rate and ask for an individual comparison rate for just the fixed rate term, assuming you refinance at the end of the term. Smart borrowers will always revisit refinance options at the end of a fixed rate term, which means the 20 plus years of variable rate included in comparison rates will distort your comparison.
Split rate tip
No lender has leading rates on fixed rates and variable rates for very long. When making comparisons, do your sums based on the largest split as a priority over the smaller one. For thinking borrowers, this often winds up being the fixed rate portion.
If you have done your own sums and genuinely feel that this is the right balance for you, by all means do it. However, make sure they are your sums, not those of a lender or mortgage broker, as they commonly recommend 50/50 because it’s an easy sale to uncertain borrowers. Like the now ‘banned’ exit penalties, the fixed proportion keeps you locked in no matter what, which equals more profit and commissions all around.
There are only two reasons to consider splitting between fixed and variable:
- The first, which is a rare requirement for investment debt, is that you are a good saver and want accessible offset facilities, which can be hard to find with competitive fixed rates.
- The second is that you only want partial protection against rate increases.
Both of these are likely to be a little silly on an investment loan. However, you should get individual advice from your accountant, an independent mortgage advisor, or a licensed financial planner specialising in property investment before you ultimately decide.
After all, it’s your money.
Michael Lee is the author of "Mortgage Free, Deb Free" and the founder of flongle.com.au
This article is from the December issue of Your Investment Property Magazine. Purchase the issue to read more.