March 05, 2014
Variable or Fixed? Which should you choose...?
Essential advice from Brisbane’s expert mortgage broker; Alan Heath of Mortgage Choice Brisbane CBD.
In this, my seventh and final Investment guideline blog, I go over perhaps the most debated issue faced when buying a property; ‘Should my home loan be Variable or Fixed?
Let’s take a look at each broken down into some finer details.
Variable Interest Rate Home Loans
As the name suggests the interest can vary at any time. The interest rate can go up or the interest rate can go down. Here is a good question for you – over the last 20 years have interest rates in general gone up or down more often? Most people will take a negative view and say that they think rates go up more often. The opposite however, is in fact true! Since 1994 variable interest rates have had a general downward trend. So the FACTS – for the last 20 years interest rates have GENERALLY GONE DOWN!!
What are some of the features of variable interest rate loans – in particular let’s rate these features as good for the borrower or bad for the borrower;
- You can make additional repayments – good – this shortens the term of the loan
- You can redraw your additional repayments at no charge in an emergency – good
- You can hold money in an 100% offset account on a daily basis which reduces the interest paid – good
- You can adjust the payments at any time to suit circumstances as long as you stay above the minimum – good
- You can repay a variable interest rate home loan in full at any time without penalty – good – most commonly this is when you sell your house ·
- You can switch your home loan to a different type (usually for a small charge) – good – this creates flexibility
- Your variable interest rate can go down – good!!
- Your variable interest rate can go up – bad!! But given that over the last 20 years variable interest rates have generally gone down, it is, in my opinion, that the good outweighs the bad.
Fixed Interest Rate Loans
Again as the name suggests a fixed Interest rate loan is not affected by market fluctuations, as a ‘fixed’ rate is locked at a specified percentage for the duration of the fixed period.
Let’s take a look at the features of a fixed rate loan;
- You are heavily restricted in your ability to make any additional repayments, in some cases you can make no additional payments without penalty – bad
- Even if you can make small additional repayments you cannot ever redraw this additional amount – bad
- With very few exceptions – you cannot have offset accounts against fixed rate loans – bad
- You cannot make changes to the repayments – bad
- You cannot repay your loan in full without paying penalties called “break costs” – bad. If you decide to sell your house you will have to pay these break costs
- You cannot switch to a cheaper product – ie. to a lower fixed rate two years into your three year period – VERY bad
- Your fixed rate loan cannot go up – good
- Your fixed rate loan cannot go down - bad
Also understand an underlying principle here; when a bank lends at a fixed rate, the bank has usually borrowed money elsewhere at a fixed rate and is lending it to you at a margin. The bank itself has restrictions placed on it when it initially borrowed to lend to you.
Clients often ask me, “Is now a good time to fix?” My answer? “The best time to fix is never!”
So why do people fix their interest rates. People generally fix their rates because they want the peace of mind of knowing their budget. In uncertain times they want to know they will be ok financially.
TWO reasons to CHOOSE variable…
1. When fixing, you will need to select a time period that you wish to fix for – usually 1,2,3,4,5,7 or 10 years. Logically, you would want to try and come out of fixed rate the very next time rates will be low. It’s now 2015 – so which year between now and 2025 do you choose to gamble your interest rate on? Even economists don’t see that clearly into the crystal ball. You also need to be sure you won’t be selling your home between now and 2025, or you face excessive “break costs”. In essence, you need to be sure that life won’t throw any changes at you that will require you to readjust your strategy over that period. For most, that is far more easily said than done!
2. Something that is rarely, if ever, spoken of. Most variable loans are now written as a “standard” rate less a discount. The size of the discount is negotiated at “point of sale” and this discount stays with you for the “life of the loan”. Fixed rates are just that – a fixed rate .. but .. When you come out of your chosen fixed rate period, what happens then?
At the moment in a highly competitive market banks are offering very generous discounts on variable loans. Let’s say you opt for a 50% variable rate / 50% fixed rate split loan and you negotiate a very generous discount on the variable component.
In three years’ time when your fixed rate loan comes out of fixed, perhaps in a less competitive environment when discounts aren’t as generous, you decide to go variable. Will you get the generous discount from the past applied or the less generous one from the present?
I can say categorically as a broker that no matter what you may be “told”, you will not get an undertaking in writing about the discount that will apply in the future, and if it’s not in writing it’s not real.
Variable loans are often looked upon as taking a gamble on the market and Fixed Loans as a stable “safe” choice.
Upon closer inspection however, it’s actually quite the opposite. Personally, I see more “stability” in knowing what percentage discount would be applied, written into the loan contract, servicing the entire life of the loan. I wouldn’t take the “gamble” of only knowing my rate commitments for period of time much smaller than the life of the loan.
THERE IS A BETTER WAY … “Fix your repayments not your rate”
You can have the peace of mind of planning a budget and keep all of the advantages of variable interest rate home loans. Irrespective of the interest rate on your variable rate home loan, pick a nominal interest rate – either the loan term average of 7%pa or if you wish to be even more conservative choose a rate higher than the average – say 8%pa. Work out the repayments and start paying them now. Any additional payment over and above the required minimum builds up in your loan as available redraw able to be taken back should a “rainy day” arrive.
A conservative view would say that if you can’t afford repayments at the long term average you probably shouldn’t be buying that house.
THE BEST WAY TO REDUCE YOUR REPAYMENTS isn’t by fixing your rate – it’s achieved by buying a cheaper house. That said, in certain situations, there are of course exceptions to the above suggestions;
- If you know that you have a period of say 2-5 years coming up when you might drop back to only one salary. This might typically be during a period of having children. If you know you simply cannot afford rates to go higher during that period then perhaps you might need to forego all the benefits of variable rate loans and ensure you take a loan for that period where the rate cannot go up.
- An investor for commercial reasons might decide to fix the interest expense for a period of time.
I will always discuss your circumstances with you and take careful note of your requests. Of course if you prefer to take out a fixed rate loan I will assist, however I will not approach this decision as many advisers do which is to encourage you to fix by creating a sense of fear and uncertainty.
Keep in mind when an adviser or a bank employee promotes fixed interest rate loans they are promoting a product that makes it harder for you to leave. Discussions with advisers or bank employees about fixed rate loans aren’t always as they seem. An employee of a bank must act in his or her employer’s best interests
The primary message here is that you need a mortgage broker to act in your interests.
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