Loan Tip: How a Fixed Loan can Cost you more Interest even when Variable goes Higher than Fixed

When fixing loans you should consider that currently fixed rates are generally higher than variable so you would be paying a premium of extra interest until the variable rates jump and cross over the fixed rates.



Here is an example with some made up interest rates, assuming no offset accounts or tax savings.



Example

Homer has a variable loan with a 2% interest rate. He reads a news report and hears that the RBA will raise rates 4 times this year – on average every 2 months. Homer believes this! Plus he thinks it rates will rise in the following year.

Homer rushes to the bank and fixes for 3 years at 4% pa.

For the next 12 months rates don’t move. He would pay $20,000 interest on his variable loan of $1mil. But if he had fixed, he would have paid $40,000 in interest. Variable is $20,000 ahead so far.

The next 12-month phase sees his variable rate increase to 3% so he would pay $30,000 variable and $40,000 fixed, he would save $10,000 as variable compared to had he fixed, so he is now ahead in total by $30,000.

In the final 12 months rates variable rates have risen to 5%. Homer now pays $50,000 in variable or $40,000 in fixed, so fixed would be saving him $10,000 pa at this point compared to variable.

He Homer fixed his loan he would be saving money at the beginning of the 3rd year, but prior to this he would have been losing money. When you add it all up Homer would have been better off in variable overall because in the first 2 years variable saved him $30,000 but cost him an extra $10,000 in the third year. Overall he would have been $20,000 better off had he gone variable.

 

My opnion is that interest rates will start to increase this year, possibly right after the election, but possibly later.

The problem we don't know how much rates are going to increase or how quickly. Fixed rates are already significantly higher than variable. They're so high that over any given fixed period I question if there is any savings to be had with fixed rates. Overall I think the time to fix was last October.

This shouldn't be taken as advice. My observation is the most qualified economists can't predict rates accourately beyond more than about 3 months. Thus the rest of us have no chance of being accurate with rate predictions.

 

Fixed rates are higher than variable when the market exectations are that future variable rates may be higher. This is normal rate curve which implies future costs are higher than present costs. Unfortunately most borrowers are only familiar with the inverse rate curve which for almost 20 years has gradually seen rates ratched down.So a variable rate is say 2% but a fixed rate is same or even less. However as you point out this is a prediction and the rate rise may be less or more than the expected. Weighted daily average dollar costing modelling can help model expected rate predictions against a known fixed rate. This tool is used in financial markets where I used to work. I have long considered sharing such a tool however dont as I consider it a matter for licensed credit advice. As its a decision helping tool it can be dangeous when used by people who dont understand the maths.

And people who lock in 1year fixed etc is often a waste of time. If you consider the longer trend is higher rates and dont expect to sell perhaps a longer term to fixed rate makes SOME sense. Depends on many factors incl whether you have or want a offset. But then the variable rate with a offset may affect the caculations as the base rate is higher. If so splitting may help so the variable can be productively offset BUT as it remains subject to higher interest managing what the split is could be important.

Trade off over fixed term duration must also be considered. As noted above 1 year may be of trivial value with a huge step up when the loan reverts to variable in a year. However 10 years may also be far too long. People on very high incomes also may have greater capacity to offset and not benefit from fixing when compared to a lower income person.

Sometimes some people may benefit from a fixed rate as it fixes their repayments from any volatity and this is likely to be upwards, not downwards !!
Choosing a fixed rate should also consider risks of incurring break costs or preventing extra repayments. eg You consider fixing 3 years but expect to possibly sell in a year.

Given the overseas example like NZ etc I see a rate increase within a few weeks of the election. Its seems the RBA has held back rates rises as a political play when it is supposed to be independent. Then it will happen quickly for at least 3-4 more. Overseas each other country has rapidly seen actual and expected 2.0% rises in mortgages once rates initially moved.

 

And this is why the majority of people don't come out ahead when fixing their loans...

If somebody is that good at predicting rate movements, they probably should work for a top bank, or investment firm. They would make much more money there than they would on going fixed v variable for their own home loans!

 

In rising markets you USED to be able to profit. In falling markets bank tend to impose break costs and be seen as winners.

I recall years back my wife & I fixed and rates rose. Bank PAID us a break benefit. Then rates started to fall so we won twice. However for many years the trend to falling rates typically meant there wasnt a massive inducement. The natural rate curve didnt favour the borrower. It favoured a lender. Until rates bottomed out in the past 18mths.

Of course banks changed their rules. Once there was a very strict "no additional payments" rule. Most dropped that under pressure from APRA and Govt and allow a tolerance eg Westpac $25K and then removed the break benefit rule to offset the cost of allowing a limited advance payment for nil cost. I dont know any lender that still pays a break benefit. They just break for nil cost.

Banks and casino's share a common issue. They will always rewrite the house rules to favour the house.