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?

fixed interest rates cost-value dilemmaWe 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.  

[We are usually requested to work on the assumption that the client would be fixing the amount for a three-year term; and comparing that with a ‘discounted rate’, variable rate loan as at the end of the previous quarter.]

Some of the questions that you may want to consider include:
– Which direction do you anticipate interest rates moving next? [This could affect both the portion of the loan you may want to fix; and the period of time for which you might want to fix.] – What timing do you believe will be applicable to the move in that direction? [This could influence the timing of your action to fix the rate of interest.] – Is the loan you would consider ‘fixing’ one that is decidedly long-term? [This is a consideration if the asset itself is not one that will be held for all of that time. ‘Breaking’ a fixed interest commitment can be expensive.] – Should you fix the whole of the debt? [If you are seeking to pay down the debt, you may not want to fix the whole borrowing. Apportioning the loan to an amount to reduce; and an amount that will be longer term may be helpful.] – How long a term should you fix any loan for? [This will be different in individual circumstances – and should be discussed with a trusted financial adviser.] – Is the loan secured against an asset that can be substituted if a disposal opportunity arises?
– Are there any business or other financial impediments to fixing all/ any portion of the loan?
…all of which we raised in our post ‘Interest Rate Fixing’ – and to which we have since added a link to ASIC’s MoneySmart site on this subject; and
what are your chances of predicting many of the answers to these issues, better than your lender? [Which will explain why the rate at which your loan can be fixed is often surprising when the current circumstances are considered – and is usually an indication as to what your lender is thinking will be the future direction for interest rates.]

Before making any decision to fix your home loan rates, contact us at Continuum Financial Planners Pty Ltd to arrange a meeting with one of our advisers who will listen to your needs, evaluate and understand your situation and provide strategic advice solutions in your best interest, that may well save you a considerable amount of money.

 [Originally posted in February 2010; this article is occasionally revised and re-posted, most recently in August 2016]