The interest rate discussion is heating up at the moment with some so-called experts saying the RBA should increase rates and others saying we can’t possibly lift rates right now. Smaller lenders who rely heavily on off shore funds have already started increasing their variable rates as countries like the US have increased rates 7 times in recent months, making the cost of funds more expensive. None of us has a crystal ball and can know what rates are going to do in the future but given the uncertainty, maybe now is the time to consider a fixed interest rate.
Looking back to look forward
I remember back in 2007 when property prices sky rocketed, the share market was flying and interest rates were in the 7%’s and everyone thought things were great. Being young dumb and full of… [just kidding] I listened to these so-called experts and fixed in for 3 years @ 7.79% with a big 4 bank. Within 6 months the GFC had hit, rates had plummeted to the 5%’s and I, like a lot of others who thought the market was just going to keep going, lost out big time.
Having the rate locked in at this rate was okay (as long as I didn’t look to closely at what I could have been paying) given it was what I was used to, plus in 2007 my property value did grow 30% in one year which was handy ;). Those were the good old days.
Now I sit down with people and especially first home buyers and we talk about interest rates in the mid to high 3%’s. Besides a little blip in the interest rate cycle up in 2011, rates have been consistently low in the 5’s, 4’s and now 3’s for 10 years.
So, it makes me wonder, is a fixed interest rate under 4% for 5 years a good deal???
It’s a long time to be fixed in for, 2 and 3 year fixed rates are certainly more common amongst our client base. However, if you knew that you were holding the property for that period of time and were comfortable with the repayments, then why wouldn’t you?
Why you should avoid a 5 year fixed interest rate
Here are some reasons not to fix for 5 years:
- Things change, you never know what is around the corner and so if you need to sell the property or move, it might mean you have to pay to break the fixed loan. More on what that means later.
- If you hold an investment property and want to access equity then you run the risk of not being able to get your money out during that time.
- You might hate the bank 6 months into the loan and having 5 years with them is too long.
- You just like to keep your options open and having a fixed rate means you are stuck there.
- If you come into a windfall of cash, get a pay rise or just want to pay down extra of the fixed loan, you won’t be able to. Generally, lenders limit you to $5,000 – $10,000 of extra repayments per annum and fixed loans don’t normally have offset accounts (only one or two lenders do have offset accounts for fixed loan).
- You think rates are going to go down lower and you can win by beating the bank.
But I’m going to beat the banks
With that last point, this is probably the most common thing I hear when talking about a fixed interest rate. We are a country of gamblers and people think that they can hold off and beat the bank. I’ve had clients tell me that their butcher said don’t fix as rates will go lower… Stick to your day job as the reality of it is, no one really knows. What I say to clients is look at your own individual circumstances and see what’s right for you. Fixing is more about security in my mind than about beating the banks.
If you did lock in a fixed interest rate for 5 years, the worse that could happen is rates go down further and you are stuck paying 3.99%. The way we normally structure a loan is to split some of the repayments on variable and some fixed, then if rates go down you will still get the benefit of that decrease on the variable rate. But in my mind the questions is – how much more can rates go down right now?
What happens when life changes?
Other things to consider are:
- Let’s face it, life doesn’t always go to plan and you may want to make changes to your lending. You may be restricted if the lender you fixed in with won’t do that. Whether you want cash out for renovations, investing in shares or property or want to change repayment type.
- If you get a huge amount of cash and can’t pay off the fixed loan or offset it. I’ve had this one where a client has inherited money in the region of $500K and fixed in for 3 years the previous year and was annoyed that he couldn’t pay off the loan. I told the client there is worse things that can happen to him and look on the bright side, YOU JUST RECEIVED HALF A MILLION DOLLARS!!!! In this case, he could have put the cash in a high interest savings account for 2 years or look to break the loan. I’ll explain how this works as it’s a pretty complex equation.
And here’s why you should look at a fixed interest rate for 5 years
The positives to fixing your loan are primarily around security:
- You lock in a great low rate for half a decade reducing the total amount of interest payable on your loan over that time compared with a potentially fluctuating variable rate.
- Consistent repayments mean security in your financial situation and budget for example if you plan on having kids and want to know what your repayments are going to be for the foreseeable future.
- Remember, rates won’t stay low forever – people in the 80’s and 90’s saw rates up at 17%.
A word on getting out of a fixed interest rate early
Back to a point I made a little earlier in relation to break costs. The break cost is what the bank charges you for ending your fixed rate contract early. To break a fixed loan is possible, you just need to get a quote on what that fee looks like at that point in time.
Here’s the formula one bank provides to explain how to calculate what it will cost you to break your fixed rate:
The precise mathematical formula for the calculation of A and B is set out below. If you do not understand this formula, we strongly recommend that you seek financial advice.
A = n ∑ t=1 Pt (1+dt)T
B = n ∑ t=1 Pt (1+rd)
I don’t expect anyone to understand the above formula, put simply the lender will look at the amount you have fixed in, the time remaining on the fixed term and what interest rate is on offer currently compared to what you fixed in for. If variable rates are much lower than your fixed rate, then you could have a big break cost, if variable rates are higher then you may get out for free as banks will win in this instance if they can on sell your money for a higher price.
So, to fix or not to fix?
Back to the question I posed at the beginning. To fix or not to fix? As with anything it all comes down to what you’ve got planned for the next few years and what your personal circumstances are. If you want to have a chat about whether fixing is right for you give me a call on 03 9421 1651 or contact us here.