Catching The Right Time On The Rate Cycle
Sydney Morning Herald
Saturday February 26, 1994
THE slightest hint of a rise in interest rates is usually enough to spark some interest in that vexed question: Should you fix your home loan interest rate or leave it floating?
This week's announcement that official US interest rates are likely to rise again in the next few months may be all the hint you're looking for that local rates are on the way up.
If that's the case, you may be thinking of locking in a fixed rate before the floating rate goes up. Often you can fix your rate for up to three years and still do better than the current variable rate of 8.75 per cent.
But your decision to take out a fixed-rate home loan should be based on more than a gut feeling about where interest rates are headed. You need to look at the overall cost of the loan (including fees), the trade-off between certainty and flexibility, and the penalty for getting out early.
Nevertheless, a belief that interest rates are at a low is certainly one reason people opt for fixed-rate home loans, says Don Stammer, chief economist at investment house Bain & Co.
A desire for certainty of repayments is the other main reason, he says.
No matter what your reason, you need to decide for how long to fix the rate and whether to fix it now or later.
"It's better to be too early than too late," says John Stroud, chief economist at funds management house Armstrong Jones.
Stroud's advice is based on his belief that interest rates will start to rise "some time over the second half of this year". Stroud believes variable home loan rates are unlikely to fall any further and would have to fall a long way for you to lose out with a three-year, fixed-rate loan.
The rate on a three-year "fix" varies between 8.5 per cent and 9 per cent, he says, compared with the standard variable rate of 8.75 per cent.
But even if the variable rate fell to 8 per cent, he says, you have given up very little for the peace of mind of knowing you are protected from the next spike in interest rates.
An average interest-rate cycle lasts about four years, he says. It is best to fix your rate for a little less than this period (say, three years), so that when you come out of the fixed-rate period, you are past the next peak.
"If you are taking a fixed position, one or two years is not long enough... and five years is a bit long," he says.
But in considering a fixed position, it is not always a matter of making a straight comparison between the current variable rate and the relevant fixed rate.
Brisbane-based research firm Cannex points out that borrowers can often take advantage of a special one-year rate (capped or fixed at about 7 per cent) before they start paying the going variable rate.
Cannex managing director Andrew Willink compares the situations of two customers, one of whom borrows $100,000 for three years at a fixed rate of 8.5 per cent, while the other borrows $100,000 at 7 per cent for one year and then pays the going variable rate.
Willink says the variable rate would need to be more than 9.35 per cent in years two and three for the fixed-rate customer to be better off.
If you assume that the fixed-rate customer goes for a five-year fix at 9 per cent instead, the variable rate would need to be more than 9.62 per cent in years two and three for the fixed-rate customer to be better off.
(This analysis assumes the application fees are the same for all types of loans. Remember, fees for switching or refinancing a loan can make a big difference to its overall cost.)
But Stephen Koukoulas, senior economist at Citibank, says the financial benefits of a fixed-rate loan are too hard to predict.
In the current interest rate environment, people are probably better off with the variable rate, he says.
Koukoulas says any interest rate movement is probably six months away at the earliest. Even then, the extent of any upturn will not be dramatic.
"When monetary policy is tightened, the effect on home mortgage rates is unlikely to be dramatic," he says.
"The days of 17 per cent interest rates are not around the corner.
"The only real benefit (of a fixed-rate loan) is certainty of repayments. The financial benefits are hard to judge."
Koukoulas thinks it is probably better to stick with the variable rate and pick up the benefits of flexibility.
With a variable home loan, it is possible to change your repayments when your circumstances change.
You can also make lump sum payments against your principal, which can help to slash your interest bill and shorten the term of your loan.
With a fixed-rate home loan, there can be a hefty penalty for early repayment and there is usually no scope to make lump sum payments without penalty.
Andre Morony, executive vice-president at Bankers Trust, says the consequences of "getting it wrong" with a floating rate are nowhere near as harmful as with a fixed-rate loan.
Sticking with the floating rate would be the "wrong" decision if the economy recovers strongly, interest rates go up and you miss out on locking in a more attractive fixed rate, Morony says.
But the potential downside with a fixed-rate loan is far worse, he says. If the floating rate drops even further and stays low, you could end up paying a lot more interest in the long term.
But worse than that, if the economic recovery stalls and your job security is on the line, you could find yourself locked into fixed repayments that you can no longer afford.
The fact that your income position is so critical to servicing a loan means flexibility of repayments is most important, says Haydn Park, manager of group corporate relations at National Australia Bank.
NAB's "tailored" variable home loan is by far its most popular product, Park says, with fixed-rate loans representing very little of the bank's total home loan business.
Home loan customers opting for a fixed-rate loan are mainly taking advantage of the bank's special short-term offers, he says, such as 6.95 per cent for one year. (The rate automatically converts to the standard variable rate at the end of the fixed period.)
In the long term, people are more concerned about the flexibility of their repayments, he says. Price is very much a secondary consideration.
But anecdotal evidence suggests a lot of home buyers are more concerned about price and/or certainty of repayments.
Fixing repayments is also very popular with property investors who want to lock in their costs and predict their future cash flow.
The Commonwealth Bank's fixed-rate home loan business has nearly tripled in size this year. And the interest has not been confined to the shorter-term rates.
Jacqui Kirkby, Commonwealth's chief manager personal market, says the bank's advertising campaign for its five-year, fixed-rate home loan (at 9 per cent) and the stronger public focus on fixed-rate products have contributed to this growth.
STATE Bank NSW also reports a surprisingly high level of interest in its 10-year, fixed-rate home loan - the first of its kind in Australia. The bank introduced the new product at the end of January and received more than 1,000 inquiries within three days of the launch.
With this product, your home loan rate is fixed at 9.95 per cent for 10 years and the loan can be carried from one property to another. There is a monthly management fee of $10 and an administration fee of $850 if you pull out of the loan within the first five years.
But if you pull out early, you don't need to contend with the usual penalty for early repayment.
You can also make lump sum payments from your principal without penalty -very unusual for a fixed-rate loan.
The possibility of an early repayment penalty is one of the most important things to remember if you opt for a fixed-rate loan, Kirkby says. If interest rates have moved down since you took out your fixed-rate loan, then you will usually be charged a penalty for pulling out early.
The size of the penalty will depend on the size of your loan, the movement in interest rates and the remaining term of your loan.
If interest rates have moved up since you took out your fixed-rate loan, then some banks (including National, Westpac and Commonwealth) will actually pay you a "rebate" if you pull out early.
Customers cannot predict the size of the penalty, Kirkby says, and they need to weigh up that uncertainty against the benefits of a fixed-rate loan.
You have to think about your personal circumstances during the fixed period you are looking at, she says, and work out the best and worst options.
If you fix your home loan rate and interest rates go down, there is an"opportunity cost" in not paying the lower rate, Kirkby says. But if you pull out early for whatever reason, there is a "real cost" in the form of a penalty.
The choice between a fixed-rate and a variable home loan must really be the individual's decision, says Bruce Freeland, senior economist at the Commonwealth. People's expectations of what interest rates will do in the future are very different, he says.
Bain's Stammer has a novel suggestion for people who can't make up their minds: fix the rate on part of the loan and leave the rate floating on the rest.
With increasing competition and flexibility in the home loan market, Stammer believes this is not an unrealistic idea.
NAB's Park says the idea of a "split" loan is not impossible, but you would probably need to pay two application fees - one for the variable component and one for the fixed component.
"I can't think of any great reason why you would want to do it," he says. "I still think you are better off taking a short-term fix and then rolling into the variable rate."
SOME OF THE FIXED-RATE HOME LOANS ON OFFER
LENDER 1 year 3 years 5 years
fixed/capped fixed fixed
% % %
Advance Bank 6.95 8.50 9.50
ANZ Bank 7.00 9.00 9.50
Bank of Melbourne 6.95 8.75 9.50
Barclays Bank 6.95 8.75 9.45
Citibank 7.95 8.95 9.95
CBA 6.95 8.50 9.00
GIO 7.90 9.15 9.80
MLC Building Soc. 6.95 8.50 9.00
NAB 6.95 8.95 9.75
Newcastle Permanent 6.75 9.00 N/A
St George Bank 7.50 8.50 9.25
State Bank of NSW 5.50 8.75 9.75
Westpac 6.95 8.95 9.50
Source: CANNEX.
© 1994 Sydney Morning Herald
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