To fix or not to fix?

Posted August 2009

To fix or not to fix? That is the question. Do you punt on interest rates going up and fix in your rate now or bet the house on rates staying low and stick with a variable loan? While I am not in the position to give advice, I have put together some background information to help you make up your own mind.

First, some definitions.

A fixed home loan is taken out at a fixed rate for a fixed period with the most popular being five years. Having a fixed rate is good for people on a strict budget and/or seeking protection from a rising interest rate market. However, breaking one can cost tens of thousands in penalties and mostly they don’t allow extra repayments.

A variable loan on the other hand is not fixed; it is subject to the ups and downs of the market and is driven by Reserve Bank policy in managing the economy. This is good if interest rates drop, because so do your repayments, but if interest rates rise, then so does your interest bill.

The Reserve Bank uses interest rates to control economic activity. It raises them to keep the inflation genie square in its bottle and drops them to stimulate demand and investment. Right now the average bank interest rate is pretty low at about 5.2% so there’s a fair bit of wriggle room upwards. But the question is when will it rise and by how much? Crystal ball anyone?

Here’s the latest economic news to help make an informed choice.

In its recent quarterly Statement on Monetary Policy, the Reserve Bank expects Australia’s economy to actually grow by 0.5% this year, leading many economists to expect rates to rise earlier than they previously figured. This renewed optimism and hence interest rate speculation is due to two things: March quarter GDP showing 0.4% growth after a 0.6% decline for December and rising consumer and business confidence. Citing all this, the bank has reiterated interest rates are unlikely to fall any time soon and most economists are now tipping rate rises for the middle of next year (although Westpac’s chief economist, Bill Evans, has been more hawkish and has tipped February.)

A few scenarios to consider.

To help, here are three scenarios which compare a $250,000 with a 25 year term over a 5 year period.

Scenario 1 – Fixed Loan for five years. At the moment the average fixed five-year rate across the major banks is 7.45%p.a.*. According to this scenario total repayments will be $110,361.29 and total interest will be $89,553.36.

Scenario 2 – Variable Loan 1
Assumes a starting variable interest rate of 5.17%p.a.* and 75 basis point rise every six months – a total of nine increases throughout the term.

Start of year 1 – 5.17%p.a.
Start of year 2 – 6.67%p.a.
Start of year 3 – 8.17%p.a.
Start of year 4 – 9.67%p.a.
Start of year 5 – 11.17%p.a.

According to this scenario the average interest rate will be 8.54%p.a., total repayments will be $120,261.66 and total interest will be $101,987.85

Scenario 3 – Variable Loan 2
Assumes 100 basis point rise every 12 months.

Start of year 1 – 5.17%p.a.
Start of year 2 – 6.17%p.a.
Start of year 3 – 7.17%p.a.
Start of year 4 – 8.17%p.a.
Start of year 5 – 9.17%p.a.

According to this scenario the average interest rate will be 7.17%p.a., the total repayments will be $106,880.14 and total interest will be $85,156.53