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Is now the time to fix? fixed vs variable rates

We continue to experience record low interest rates due to a decrease in the official Reserve Bank of Australia cash rate to 0.25%. These rates are being passed onto the banks and making it more affordable than ever to take out a mortgage. Due to the low interest rates that banks are offering, you will pay less interest on your loan, and will also be able to pay more principal. This means that now is a great time to borrow and get on the property ladder.

When borrowing to purchase a property, you have the option of a fixed or variable interest rate. Whilst you may prefer one more than the other, it is worth considering the impact that the current record low interest rate environment has on each of these options.

What is a fixed rate?

A fixed rate can be classed as a predictive rate set by the banks that means the customer must pay that same rate for a set period. Some lenders offer fixed rates between 1 – 10 years but most fixed rates are commonly offered between 1 – 5years.

Once you have confirmed your fixed rate with your lender, you will begin paying that rate for the remainder of your agreed fixed term, regardless of whether interest rates fall or rise.

Benefits of a fixed rate

The main benefit of a fixed rate is that if rates increase during your term, your rate (and payments) will remain the same. This could potentially save you a lot of money if interest rates increase during that period. Another benefit of a fixed rate is that you can budget for your payments, as you have certainty regarding your repayment. This might be important to homeowners or an investor, who is comfortable with current monthly repayment, but is concerned that a rise in rates could have a significant impact on their financial situation. It’s not uncommon to see many first-time homeowners and investors fix their rate, as they crave certainty for an expense that was previously not part of their regular budget.

The most common fixed rate terms are typically between 12-36 months, as purchasers can lock in an element of certainty without being overly exposed for the long term if rates start to fall.

Disadvantages of fixing

If you’ve taken out a fixed term rate and interest rates across the market begin to fall, you could find your fixed rate is no longer competitive. A fixed rate is less flexible than a variable rate, as you cannot easily switch between products and lenders before the fixed term expires without suffering a penalty.  Generally, the penalty is greater than the benefit of breaking the fixed rate, as it’s the banks way of deterring you to move.

Another consideration with a fixed term rate is that you are limited to how much you can overpay your loan. You are typically penalised for early repayment of the loan beyond a limited amount, which may affect borrowers with surplus cash that could have been placed onto the mortgage to reduce monthly repayments. The same penalties can apply if you wish to sell your home and repay the loan early.

Whilst one of the major disadvantages for fixed term rates is the potential for rates to fall and your fixed rate to become uncompetitive, it should be noted that in the current climate this potential risk has limited downside. With major banks offering fixed rates from 2.09% and with the RBA rate at 0.25%, it is hard to imagine banks offering rates significantly lower than their current levels. Whilst an RBA rate could fall to 0.0%, it is not guaranteed that banks would pass on these cuts as they are still required to generate a profit which typically requires a margin of approximately 2% above RBA base rate.

What is a variable rate?

A variable rate can be described as a reflection of the current economic climate. Variable rates typically follow the RBA base rate and they tend to increase when the RBA wants to ward off inflation or slow down the property market. Conversely, the RBA tends to reduce rates when they want to kick start the property market and reduce existing borrowers’ repayments to increase consumer spending.

Advantages of a variable rate

An advantage to a variable rate is that if interest rates continue to decrease due to the recent impact of COVID19, your interest rate will also drop depending on the banks decision to pass this on. We must remember that the bank still has to charge a margin to become profitable, so if the cash rate continues to fall, the banks might not pass this rate on in order to maintain their margin.

A major advantage of a variable rate loan is that you can overpay via an offset or redraw account, without suffering any penalties. This means that you can have a transactional account linked to your home loan, and the money sitting in that transactional account offsets the amount of money on your home loan. Simply, this means that the more surplus cash you have in your offset or redraw accounts, the less interest you will have to pay.

Disadvantages of a variable rate

Due to the fluctuating nature of a variable rates, the major negative will be lack of control over potential repayments which can increase in a market of rising interest rates. This makes it harder to budget and meet your repayments, especially when your regular income may be capped at a certain level.

Splitting your loan – can you have your cake and eat it to?

If you’re looking to take advantage of record low fixed rates, but don’t want to sacrifice having the ability to utilise an offset or redraw account, there may be a way you can have your cake and eat it to. These days most banks will allow borrowers to split their loan – this means they can fix part of their loan, whilst providing the ability to have the remaining part of the loan as a variable rate.

A recent Orium Finance client was renting a property for $4,300 per month. They realised that with the record low fixed interest rates, they might be able to realise their goal of home ownership whilst the mortgage repayment was similar to their monthly rental payment. Managing Director, Luke Heavey explains how “we split the loan into two so the client could have the security of an extremely low fixed rate that was only slightly higher than their monthly rent, whilst at the same time having the flexibility to offset the variable component of their loan with surplus cash.”

Loan Amount Rate Term Monthly Repayment
$353,700 Discounted Variable rate of 2.95% 30 years Principal & Interest $1,482
$825,300 Discounted 2 year fixed rate of 2.29% 30 years Principal & interest $3,172

By splitting the loan into fixed and variable, our client was able to reduce their monthly repayments to $4,654, which was only slightly higher than their monthly rent of $4,300. Any surplus cash they have was placed into their offset account, which can be accessed whenever the need.

 Does now represent an ideal opportunity to fix?

It seems that with the impact of recent economic events and the large disparity between fixed vs variable rates, now could be as good a time as any to consider fixing all or part of your loan. With rates across the lending environment at all-time lows, the variance between fixed versus variable rates is further exaggerated. For example, when you compare a fixed rate of 9% versus a variable rate of 10%, the percentage difference between the two rates is only 11%. However, when you compare the current fixed rates of approximately 2% versus the current variable rates of approx. 3%, then the percentage disparity between the two rates is 50%.

The information provided in this article is general in nature and does not consider the specific needs of each borrowers’ individual circumstances. Get in contact with the Orium Finance team to understand how a fixed rate might apply to your personal circumstances.

 

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