Fixed Interest Rates may not be in your best interest
Why wouldn’t fixed interest rates be to your advantage, especially at times when the rates seem low compared with previous times?
We are occasionally requested to advise clients about the prospect of fixing the interest rate on their home mortgage. Whilst the question of fixed interest rates is usually raised around the time of any ‘move’ on the Official Cash rate by the RBA, it does arise away from that cycle as well.
In the process of answering these questions, we have often been able to demonstrate that there are disadvantages in ‘fixing’ at the wrong time in the cycle. In one instance, we found that prior to the RBA rate rise announced a week earlier, the RBA would have had to raise their official rate by 25 basis points every two months for the following 18 months (and the banks match that rate each time) before it might have become beneficial to have fixed prior to the announced increase.
Why interest rates fluctuate over time
There are two key reasons why interest rates fluctuate; and another as to why they vary as between the different lenders. The two key reasons for fluctuations are –
a) the Reserve Bank of Australia determination on Official Cash rates; and
b) the economic consequences of supply and demand.
The Reserve Bank of Australia
The Reserve Bank of Australia (RBA) regularly meets to decide on the appropriate interest rate to apply to its lending to the Banks. The RBA meets on the first Tuesday of each month for ten months of the year, to consider – and if it believes economic circumstances are appropriate – adjusts the Bank lending rate, usually in 0.25% (25 basis points; or bps) increments. This announcement only affects the rate of interest charged by the RBA to the Banks. Other influences cause the rate charged to borrowers outside of the banking system to be charged at a commercially prevailing rate.
Money Supply and Demand
Whilst the Banks pay the Official Cash Rate to the RBA for that portion of the funds they lend, they also have to source funds from investors. These funds are in the form of Term Deposits and other borrowings including Bank Bills. The rate of interest payable by the Banks for these funds significantly influences the interest rate they charge to their customers. If there is a lot of money available, but not enough borrowers to absorb these funds under prudent lending conditions, interest rates stay low. If on the other hand, investors are looking to acquire assets with borrowed funds at a faster rate than the Banks can secure funds to lend, interest rates will increase.
Competition between lenders
In response to the RBA action, all of the major banks adjust their Variable – and their Fixed – rates by an amount appropriate to their circumstances: and not always by the same amount (either as each other, or as the RBA!). Remember that the supply/ demand question comes into play; that each Bank may have a different ability to raise funds at any given interest rate; and each of them has a different cost structure for processing the flow of funds and managing both their lenders and their borrowers. These factors affect both the variance in interest rates between the major lenders; and the capacity for each of the Banks to ‘pass on’ the rate variance introduced by the RBA.
Fixed interest rates benefits
The relative benefits of fixed interest rates only marginally change with the changing base rates. Particularly in relation to non-tax deductible interest the consideration stays the same: be aware of the ‘variables’ in your own circumstances before you take a decision to fix any substantial portion of your home loan mortgage.