The Reserve Bank has made it clear that the next rate movement is likely to be upwards so is now the right time to be fixing your rates?  The answer is a combination of some basic mathematics, the toss of a coin, and the wisdom of hindsight.

With the wisdom of hindsight we can see that the best time to have fixed your rate was last March.  At that stage variable and fixed rates were about the same but since April all the banks have been progressively increasing fixed rates.  Taking the Commonwealth Bank as an example their three year fixed rate was at its lowest in late March/early April at 5.75%, sitting about the same as its variable rate.

The Commonwealth Bank’s three year fixed rate is now at 7.14% which is 1.4% higher than their variable rate.  Other lenders will have similar rates.  So here is where the mathematics comes in.  A loan of $300,000 at the variable rate of 5.74% will have interest payments of $1,435 per month while the same loan at the three year fixed rate (7.14%) will have interest payments of $1,785.  So you have a guaranteed higher payment in the short term.  (I have used an interest only payment for simplicity but the story is the same when paying Principal and Interest). 

The question is what will happen if rates rise?  For comparison purposes let’s look at one scenario where the variable interest rate increases by 0.25% each quarter over the next three years.  So that means that the variable rate in three years time will be 8.49%.  This is your breakeven scenario where both the fixed and variable rate loans cost the same - a little under $64,500 in interest over the three years on the $300,000 loan.  

So this is where the toss of the coin comes in. You have to decide whether the bank analysts have their fixed rates set right or wrong.  If you think rates are going to be over 8.5% in three years time then maybe you’re prepared to accept the higher repayments now to avoid the risk of higher rates. 

The other consideration you need to take into account is whether there is a chance you will discharge your loan over the time you fix your rate.  If you do then you could be faced with substantial break costs.  The calculation of these break costs vary from loan to loan so it’s not easy to say what they will be.  But what I can say is that if you break your loan when the variable rate is below your fixed rate you could be in for substantial costs to discharge. 

So here is another option for you to consider.  Keep your variable rate but pretend that you are paying the fixed rate.  So in our scenario above you would start paying $1,785 into your loan account which would be building your redraw by $350 per month.  So by half way through your imaginary three year fixed period you would have $6,300 sitting in your redraw if rates don’t increase.  If rates rise then you keep your repayment the same by reducing your extra payment into your redraw. 

Eventually if rates go above your imaginary fixed rate your start using your redraw to contribute to your repayments.  This way you flatten out the peaks and troughs of interest rate changes.  What’s more the extra repayments you are making help to reduce your interest cost rather than increase them.  

The moral of the story here is that fixing is best done when rates on the way down – hopefully at or near the bottom of the cycle.  However effective use of your redraw facility is over the longer term likely to be a cheaper and less risky strategy when you consider the uncertainty of predicting the future and the break costs of fixed rate loans. 

I hope this has been a clear explanation for you but if you have any questions I’d be happy to answer them.  Just click on “Message Us” below.  Also keep in touch with more articles and news from me at: 

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Regards  

Paul Thewlis

Onyx Finance

www.onyxfinance.com.au