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Variable vs Fixed Rate Loans – Which is Best in the Current Climate?

27/04/2020 by Pascoe Partners Accountants

Variable vs Fixed Rate Loans – Which is Best in the Current Climate?

 

With interest rates at all-time lows, we have been getting plenty of questions about home loans.

The age-old question of variable vs fixed rate loans is the most common question and we’ll try to unravel that below…

What’s happening with variable interest rates?

The Reserve Bank may have the cash rate at 0.25% but this does not mean that you will get that rate from your bank.

Banks will argue, and rightfully so, that they do not “buy” the funds they lend at that rate. There is also a profit margin built into the rates that banks charge you as the borrower.

Currently, we are seeing owner-occupied housing rates below 3.5% for variable loans and, for small businesses, loans at rates less than 5.5%.

Certainly, the business loans have not tracked down like housing loans as the Reserve Bank reduced its rates.

You should also note that there is a difference between new loans and the rates charged on existing loans. One of the reasons for this is that the banks are trying to attract new business.

Should I switch to fixed interest?

Fixed rates are generally higher than the current variable rates because bank research suggests that the interest rates are likely to increase over the fixed term.

Generally, when opting for a fixed rate loan you are betting that the variable rate will increase to more than the fixed rate over the term. The bank is betting against that happening.

So, if fixed rates are more expensive, why would you go down this path?

There are pros and cons, of course.

MAIN PROS:

  • Variable rates may increase to more than your current fixed rate over the term so that you end up paying less interest. With this approach, there is the gamble that rates may be cut further but with the current rate so low this is unlikely.
  • Fixed rates provide certainty on what must be paid for cash flow management purposes. There is no doubt about the repayments or the interest that will be paid.

MAIN CONS:

  • You cannot make additional repayments on the loan should surplus funds be available. You may be able to achieve the same effect with the use of an interest offset account but these are out of favour with the banks.
  • If you need to refinance for any reason, the bank will charge a break cost to get out of a fixed rate loan. They will generally calculate the difference between the costs incurred in lending the money against what would have been paid on the loan. A simple example: with a $100,000 loan at 5.5% interest for two years that is now a variable rate of 4.5%, the break cost would be $100,000 at 1% for two years.

Variable vs fixed rate loans: it’s not necessarily one or the other

If you’re weighing up the pros and cons of variable vs fixed rate loans and are undecided, there is another option: mixing the two.

In fact, we suggest that you don’t put all your eggs in one basket. Rather than switching completely to a fixed rate loan you can fix a portion of the loan and then keep the rest at variable rates.

You will get a reasonable mix of rates but also have the option of making extra repayments against the variable portion.

Ask yourself whether you have a compelling need to fix the rate at this point in time?

The best solution may be to wait. We believe that there will be significant competition between the banks to try to get market share in the near future.

One of the ways that they can achieve that is through interest rate deals.

This may not be across the board but could be specific to industries or applications. Once you have fixed a loan, there is very little room to move to take advantage of such opportunities.

Please contact Casey at Pascoe Partners Finance for further advice.