The sharpest home loan rates available are fixed but not always the best option. In this update we talk about considerations when opting for a fixed rate loan and why they are so low.
Why fixed rates are so low
The difference between variable and fixed interest rates on home loans is now so significant that many people are jumping to fix their rates.
The lowest advertised rates are fixed and are hovering around 2.19% - 2.29%. This makes them between half a percent or more lower than a standard variable rate option, but just because the rates is lower it is not always the right option.
Before going into the details lets take a moment to talk about why fixed rates are lower.
Over the last decade or more the most common type of interest rate on a home was the ‘standard variable rate’.
This is usually the headline rate banks advertise and that most borrowers went with. It was and is also the most common rate that banks discount behind closed doors to get new customers.
But a shift is occurring, and that shift is making fixed rates more appealing.
I am trying not to sound too cynical but the reason for this shift in the marketplace is largely because it is better for the banks, rather than borrowers. That is not to say there are not benefits for borrowers, but saying the shift is being driven by banks and their desire to benefit, over their desire to give benefits to borrowers.
The reason it is better for the banks is that it secures income.
During recessions like the one we are in right now having guaranteed income is very valuable, and because the majority of banks incomes comes from home loans, having borrowers on fixed rate home loans for two or three years guarantees income into the future.
That certainty is valuable.
Especially because banks are facing billions of dollars of potential losses.
Another significant reason why fix rates are lower than variable is because of the cost of capital for banks at the moment is so cheap.
The RBA cash rate is sitting at 0.25% which is the lowest on record. And there is a (small) chance it could hit 0%.
I wrote in an update in October last year predicting QE and that the cash rate to hit 0% or even turn negative and this is looking increasingly likely.
Since the start of the virus crisis the government also announced a $90 billion dollar funding scheme designed to reduce the borrowing costs for banks, so they offer low rate loans to customers. If you recall in previous updates we have talked about how banks profit from borrowing themselves as cheap as possible then lending it to people to buy homes, and the difference in the middle, the net interest margin, is where they make their money. So, by the government making it really cheap for them they should be making it really cheap for borrowers.
But that scheme only runs to September.
Depending on how the economy fares over the next few months will determine if this cheap funding scheme is extended or not. If it is not extended, we could see fixed rates move up in price and close the gap on variable rates.
So, the question is…
To fix or not to fix
Just because fixed rates are lower does not mean it is the best option - for you.
As with most complicated questions in life the answer seems to always be it all depends.
In this case, it depends on your near-term future income, expenses, requirements, and perspective.
The advantages to fixed rates are that they provide you with a cheap rate and the same repayment amount for the next few years. This gives certainty in an uncertain world.
Further, because fixed rates can be quite lower the overall out of pocket repayments you make can save you money.
For example, if you have a 30-year loan of $700,000, for the place you are living (owner occupied) and paying down the balance each month (principal and interest repayments) with a rate of 2.75% your monthly repayment is $2,858.
In the same situation with a fixed rate of 2.29% over 2 years the monthly repayments would be $2,690.
If we add up all the monthly repayments for both scenarios over 24 months you pay $4,032 less overall out of pocket on the fixed 2-year option than on the variable rate.
That is a nice chunk of change to save.
But, there are downsides with fixed home loan products.
Mostly notably is that fixed home loan products (often) do not have an offset account, redraw function and have limits on how much extra you can pay down your loan during the fixed period.
All of these loan features, especially the offset, could save you money and potentially even more than the $4k in the above scenario.
To further complicate things you do not need to have one or the other, you can have both rate types on your home loan. You can have half variable and half fixed for example, or 60/40, or 80/20, whatever split you like and makes sense.
It really depends on your specific set of circumstances and requirements, and this is where working with a finance broker like Skyward Financial could save you time and money. If you are interested to run a calculation to compare your options Let’s Talk.