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Interest Rates: the great fixing debate

With interest rates now on the march upwards a lot of people are considering fixing their home loan interest rates, but are they too late?

The Reserve Bank of Australia (RBA) lifted the cash rate by 0.25% in October and again in November. These increases flowed directly on to borrower’s variable rate home loans, seeing the monthly repayments on a $300,000 home loan increase by $125. This has prompted a lot of home owners to consider whether to fix the interest rate on their borrowing.

When considering fixed rate home loans it is important to understand that fixed rates are not set from the RBA cash rate in the same way as variable rates. Instead the banks set fixed rates based on their forecast of future interest rate movements

For this reason we have seen fixed rates steadily increasing from very early in 2009 when the banks started to forecast the cash rate would begin increasing later in 2009, as it now has. In late 2008 it was possible fix your home for three years at lass than 5% and now you can’t fix for this term for less than 7%.

So is it too late to fix your home loan interest rate?

To answer this question you first need to consider why you want to fix your interest rate and there are really only two reasons to fix:

1. Your monthly cash flow is tight and you need the certainty of knowing how much your scheduled repayment will be for a number of years. In this situation fixing your rate enables you to comfortably budget your income for a number of years without the looming uncertainty that you will be hit by increased home loan repayments.
2. You are firmly of the opinion that variable interest rates will continue to increase, to the extent that they are higher than the fixed rates currently available. For example if the variable rate is 5.5% and you can fix for three years at 7.3%, then you need to believe that variable interest rates will increase by more than 1.8% in the foreseeable future. In this situation your monthly repayment would immediately increase by a significantly amount if fixing, so the variable rate needs to increase by more than 1.8% in around 18 months so that you have the opportunity to save money on your repayments during the second half of your three year fixed rate term.

If you agree with either, or both, of these reasons, then fixing your home loan interest rate should be a consideration. If you are unsure that fixing is the right thing to do then there are a couple of different strategies to consider.

Firstly you can have an each way bet and fix half of your borrowings whilst leaving half on a variable rate. This strategy has the affect of locking in the prevailing financial climate to your borrowings. As the climate changes, with interest rates moving upwards or downwards, half of your borrowings will be advantaged and half will be disadvantaged. This strategy does reflect a degree of uncertainty and when uncertain the best course of action may be no action.

An alternate strategy to address rising interest rates without the need to commit to higher fixed rates is to build a buffer in your variable rate loan. This buffer will help to supplement your repayments if variable interest rates continue to rise.

But how do I build a buffer?

Simply calculate what your monthly repayment would become if you were to fix at the rates currently available and then adjust your repayment to that amount immediately. You will then start building a buffer in your home loan through your extra repayments. It is this amount that can be used to supplement your monthly repayment if the scheduled repayment ever increases beyond the revised repayment that you have instigated.

Using the $300,000 loan previously mentioned on a 30 year loan term, combined with a current variable rate of 5.5% and a three year fixed rate of 7.3% you would have the following result.

Current monthly repayment @ 5.5%	$1,703
Monthly repayment @ 7.3%	$2,057
Monthly savings to build buffer	$354

The beauty of this strategy is that it has the exactly same impact on your monthly cash flow as if you were to fix your interest rate. Yet you still benefit from the currently lower variable rate and have the opportunity to build up a cash buffer within your home loan. Better still, if variable rates don't get to the same level of current fixed rates within the fixed rate terms, then the buffer will help to pay off your loan faster; potentially saving you years.

To see how this strategy could work for you HOME Mortgage has a range of free calculators available including a Home Loan Repayment Calculator that can assist you with the above calculations. The HOME Mortgage homepage also has indicative interest rates listed to help with these calculations.

Jeremy Kruse is a home loan expert with HOME Mortgage, email Jeremy at jkruse@homemortgage.com.au

 

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