Mortgage Broker – Established Residential Investment & Home Loan Specialist

Fixed VS Variable

Fixed VS Variable

 

A question many people ask me, ‘Should I fix my loan?’ My response is always the same, that being, fixing your loan is like gambling. If you fix your loan you are essentially having a bet that you believe rates will go up. Canstar, a financial watch-dog did a study over 20 years of people who had a fixed rate loan and found that 85% of them would have been better off with a variable rate loan. Another words, 85% of people took a gamble on their biggest debt in their life, and got it wrong! I am writing this article Fixed VS Variable to highlight the dangers of fixing your loan and how to manage your finances in such a way that rising interest rates will never become an issue.

 

Fixed VS Variable – Economic Cost

 

The biggest negative about fixing your home loan is the ‘break fees’. If you get it wrong and want to switch from a fixed rate back to a variable rate be warned… You will have to pay what is called Break Fees. Not only does the bank charge you a fee to switch but if the variable interest rate is now lower than the fixed rate you are currently on, you will have to pay an Economic Cost and you have to be a mathematician to figure out yourself how much this will be.

So for example:

  • You fix your $300,000 loan for 7% over a 3 year period
  • A year and a half later the variable rate drops to 6.50% and you say to yourself, ‘I want to stop paying this higher rate of 7% and switch my loan to a variable loan’
  • Firstly the bank will charge a switching fee, anywhere from $100 to $300
  • But then the bank will charge you an Economic Cost, which is the difference between the old rate and the new rate
  • Essentially an economic cost will cover the banks losses. They were receiving 7% for your fixed rate loan, which they booked in that profit for a 3 year period and now that you are going to switch to a variable rate of 6.50% they will lose 0.50% on a $300,000 loan for the next year and a half.
  • This is not the true calculation but for a simple example $300,000 times by 0.50% = $1,500 times by a year and a half = $2,250
  • So now the cost for you to switch, for example is $2,250 Economic Cost and $250 Break Cost totaling $2,500

 

Fixed VS Variable – Is It Worth It?

 

Following on from the above example, whenever breaking a fixed rate loan for a cheaper interest rate you have to ask yourself, ‘is this worth it?”

Having a lower interest rate will reduce your interest monthly repayment but now you have a higher debt and it has cost you money to switch.

$300,000 @ 7% = $1,750 per month in interest VS $300,000 + Fees of $2,500 = $302,500 @ 6.50% = $1,638.54 per month in interest. This represents a saving of $111.46 per month. We now need to multiply this saving over the remaining time left on your fixed loan, in the example above a year and a half or 18 months.

$111.46 times by 18 months = $2,006.28 total savings having a lower interest rate

So in summary it has cost you $2,500 to break you fixed rate loan and all you have saved is $2,006.28 over this same period, therefore by switching you have made a loss of $493.72.

The worst I have seen is a client with a $650,000 loan fixed for 5 years at 8.57% with the CBA and wanted to switch to a variable rate that was now about 6.40%. From memory the Economic Cost was about $85,000! But I could save him about $2,000 per month in loan repayments, unfortunately he still had 3 and a half years left to go. So I crunched the numbers and found that he would have been better of if he stayed in the fixed rate product, otherwise the end cost was going to be around $10,000.

I have NEVER seen the numbers work in the favour of breaking a fixed rate loan when the variable rate is lower than the fixed rate.

 

Fixed VS Variable – Other Factors

 

So now you can see if you get it wrong, it is going to cost you money to switch if you chase a lower interest rate but there are other losses that can occur that you may not be aware of, for example:

  • Your opportunity to refinance to a lower Variable Rate
  • Your opportunity to refinance your current loan to access equity to purchase a new car, purchase an investment property or assist a family member in need etc.

I have seen in the past where the lender has come out with a special discount for ‘new loans’, meaning all of their existing clients stay on the variable rate they are on but new clients will attract a lower rate. In this circumstance it is sometime viable for you to make this type of switch but again, if you have a fixed rate loan the break fees will normally obsorb any of the benefit of the new lower rate.

Worse still, lets us say you have taken out a 5 year fixed rate. During the first 2 years property values go up and you are now in a position to buy an investment property but to do so you need to refinance your home so you can access enough equity to cover the deposit, fees and charges to buy the investment.

Problem is, you cannot refinance your fixed rate loan without incurring break fees. So by fixing your loan now may stop you from buying an investment property in the future because of the costs involved to access your equity.

Nobody knows what the future hold, sure you can have goals, dreams or plans but life is known for throwing the occasional curve ball like:

  • Injury or sickness
  • Loss of job
  • Change of job, including relocating
  • Job promotion, higher wages and now having the ability to afford an investment property
  • Unexpected pregnancy
  • Overseas family member becomes ill
  • Etc.

You can book a holiday of your lifetime 12 months before you actually leave but you cannot guarantee that you will be healthy, in your same job or still alive by the time your holiday date comes around. Yes we all take chances in our life but gambling on a perceived certainty on the largest debt in your life, I personally cannot recommend.

I have seen financial leaders recommend in articles that clients should look at fixing their loans, only to see 2 years later the rates still falling. If you had of taken these guys advice you would have lost big time.

I can totally understand why people fix, the main reason so they know exactly what their loan repayments are going to be over the next 2, 3 or 5 years but there is a better way to manage your finances and have certainty and flexibility when life changes unexpectedly.

 

Fixed VS Variable – A Better Way

 

When you apply for a loan the lender will see if you can afford the loan repayments, on average, as if the loan interest rate was 2% higher than the actual rate you are applying for. Example:

  • You apply for a $300,000 variable rate home loan @ 7%, which has a Principal & Interest payment of $1,995.91 per month
  • The lender assesses your ability to repay the loan as if the rate was 9%, which has a Principal & Interest payment of $2,413.87 per month

The reason why the bank does this is because the last thing they want is to lose money and if they have to foreclose your property, they will lose money. So if rates go up, they know from the information you have provided in the loan application that you can afford the repayments if this was to happen.

My simple rule is, pay the extra 2% from when the loan settles.

This will not only save you thousands in Bank Profit (Interest) but will also save you years off your loan term, better still it will insulate you from future rate increases.

 

Fixed VS Variable – Summary

 

As you can tell by the tone in my article, I am not a believer in Fixed Rates.

Hot Tip: When you receive your next pay rise, for example you receive an extra $100 per month in your pay packet (about $1 per hour increase) take 50% of this money and add it to your loan repayment and the other 50% go and spend it on whatever you want. By doing this you will insulate yourself from future rate rises. By doing this in addition to paying your loan as if it was 2% higher than the current interest rate will allow you to maintain your repayment even when rates rise.

You are now in control of of your finances in such a way that a rate rise, or even multiple rate rises does not effect your budget. You will be able to maintain your current loan repayment during a rate rise and you increase your repayment when you receive extra money in your pay packet.

Never allow the lender to dictate what you should be paying per month, you need to take control over your loan repayment and pay what you can afford from the outset.

I hope this gives you a better understanding of the ramification of fixing your loan and ways to mitigate future rate rises.

 

Nathan Daniell
Managing Director
Simplify Your Mortgage Pty Ltd

 

P.S. I hope you have found my article on Fixed VS Variable useful as I plan to write more articles in the future.

 

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