Interest rates

Mortgage interest rates are on the rise. How do I know whether to take out a fixed or variable loan?

I really don’t like making a decision when the information needed to make it is incomplete: chances are you’re wrong.

By now we all know that interest rates are going up. This means mortgage borrowers will have to pay more, in some cases hundreds of additional dollars per month, to pay off their home loan.

But there is a twist. The amount of money you will accumulate depends on whether you have a fixed or variable rate loan, or a combination of both. You have to choose the best option and this one will probably be the most affordable for you.

So which one is it?

The decision was easy

At the start of the pandemic, the Reserve Bank cut its cash rate to almost nothing.

Fixed rates also fell. A record number of borrowers switched to a fixed rate loan because they were able to lock in a one-time low rate in a generation for up to five years. This also worked in favor of the banks, as they were looking for funding certainty at the time.

At one point, about half of all borrowers were on fixed rate loans.

RateCity.com.au’s analysis of the Big Four banks’ annual reports now shows almost 40% of borrowers have a fixed rate home loan, with the majority of fixed terms set to expire from mid-2023.

Hangover for fixed rate borrowers

As you can see, the proportion of borrowers on fixed rate loans is starting to fade. Part of the reason is that for many the math no longer works.

Rate City’s analysis shows that people whose fixed rates end could potentially experience repayment increases of more than 40%.

For example, if someone with a $500,000 loan, paying both principal and interest, pegged in July of last year to peak at 1.94%, they would currently be paying $2,105 in monthly repayments.

When their fixed rate ends in July 2023, they would be looking at an average rate of return of 5.68%, should Westpac’s forecast for the cash rate materialize. Their monthly repayments would increase to $3,042, an increase of $937 per month.

Even if they managed to renegotiate their loan at the banks’ lowest variable rate, they would still pay 4.42%, more than double what they are currently receiving, with an increase in monthly repayments of $600.

Extraordinary spread

Further analysis by RateCity also shows that the spread between variable rates and fixed rates of the big four banks has exploded over the past year.

Twelve months ago, for example, the Big Four banks’ three-year average fixed rate for homeowners paying principal and interest was 0.68 percentage points lower than the lowest average variable rate.

Today it is 2.57 percentage points higher.

Three-Year Average Variable and Fixed Mortgage Interest Rates(By RateCity)

This difference is similar to the extent to which some forecasts show that the cash rate will increase over the next two years.

While variable rates are expected to increase over the coming year, fixed rates will also increase.

The latest US inflation data shows consumer prices at their fastest pace since the 1980s. This means the US central bank will tighten monetary policy further – which could be quite significant – and this will affect Australian fixed rate mortgage rates.

There are other things to consider

It is also important to consider your personal situation. For example, if you don’t plan to move after buying a house, a fixed rate may make more sense. However, if you lose your job or have to relocate for any reason, you will incur termination fees on this loan, which can amount to tens of thousands of dollars.

Indeed, it is the severance pay that adds “drama” to the decision-making process. It’s called a “fixed” rate for a reason – you’re literally locking yourself into a series of mortgage payments and any move away from it is designed to hurt, financially.

Another issue is that you usually cannot make additional loan payments on a fixed rate mortgage.

But a crucial decision borrowers must now face is whether to “lock in” some sense of financial security now, by going for a fixed rate, or choose a variable rate and hope they don’t rise too much. .

This column does not seek to provide financial advice but to encourage you to think about whether you are in a position to borrow to buy a house.

The only thing I will say is that it is clear that borrowers are now paying a significant “premium” for one, two or three years of relative financial security with a fixed rate.

We also know for sure that interest rates will continue to rise as inflation rises, and banks need to manage this by structuring their loan portfolios. So whatever loan the bank offers you, you know for sure that it is in their interest.

The question is whether or not it’s in your interest too.

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