Fixed or Variable Interest Rates

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With three year fixed interest rates significantly lower than variable interest rates (at least 1% at time of writing) borrowers are again weighing up whether it is better to fix their interest obligations, maintain a floating exposure or a combination of the two.

This article looks at the drivers of the current difference and aims to assist those who are currently deliberating on which approach to take.

Like all such considerations your individual circumstances will drive a significant part of the decision. All advice is general in nature only. 

Fixed Interest Rates

The interest rate is generally fixed for a period of one, two, three or five years (sometime longer). During this period the borrower’s interest expense obligation is known and certain. Fixed interest rate loans are generally more restrictive, as there can be break fees associated when exiting the loan early.  Fees may also be associated with early repayments, which means even though you may be able to afford to pay down the loan to reduce your interest obligations, you may still need to pay the fixed interest amount agreed to.

Where personal circumstances matter.  If you are progressing in your career and you earnings potential is increasing, you may wish to have the ability to make additional repayments to reduce your loan and interest expense, as your income increases. While some fixed loans permit repayments up to for example $10,000 p.a., making significant extra contributions would be difficult.  

If you cannot manage fluctuations in the cost of servicing the loan and have a relatively stable income outlook than a fixed interest rate may be the best approach, as you ability to service the loan will not be comprised should interest rates suddenly increase.

Variable Interest Rates

Variable interest rate loans are generally more flexible, and often offer more attractive features, such as introductory offers or honeymoon periods.

The potential for higher interest costs, should the cash rate increase, often scares a lot away from variable interest rate loans, however this exposure if not necessarily something to be overly worried about. The reason interest rates rise is often to contain inflation, which occurs when the prices of goods and services increase, as prosperity, wages and assets prices rise.  Therefore, most people are generally in a better position to absorb their increased interest expense as they are earning more and their wealth increases.

This is not to say a substantial buffer shouldn’t be taken into account when calculating what interest payments can be maintained, should interest rates increase.

Why the Outlook Matters

There is often a very good reason why fixed rates are below variable rates, as they are now. In Australia the ASX cash rate futures market indicates the market expects the cash rate to fall from by 1% from 3.5% (Sep-12) to 2.535% by Jul-13.  This is often due to a deteriorating economic outlook, where the RBA is predicted to lower the cash rate, subject to inflation remaining within target guidelines (as is currently the case, on an underlying basis).

This current market pricing enables the banks to secure funding to offer the lower fixed interest rate loans we are currently seeing. The fixed rates therefore reflect the market’s outlook for a falling cash rate. So in essence if you secure a fixed rate loan today, you are effectively agreeing with the current outlook.  

If however the economic situation improves or deteriorates more than expected and over a period different than the term of your loan, you are potentially putting yourself in a costly situation.

Given the uncertainty of the market, and the unpredictability of future interest rate movements, most academic studies have proven that maintaining a floating (variable interest rate) exposure is desirable.

So Which Is it?

Fix where prudent and personal circumstances require i.e. a fixed interest expense is required if your forecast income is also expected to remain static. This ensures you can service the loan, for the duration of the fixed term.

A variable interest rate exposure however is generally preferable, where personal circumstances do not dictate otherwise, as the benefits from repaying the loan sooner can be very significant. You are also not in a position where you are effectively gambling on future interest rate movements, which is essentially what you are doing with a fixed interest rate loan, and let’s be honest, most, if not all of us, have absolutely no idea which direction interests rates will move.

Some experts advocate a split approach, which provides the ability to repay a substantial portion of the loan (the unfixed component), while ensuring payments aren’t too variable, as the repayments on the fixed portion remain static. This will suit many, but remember, you will not be receiving the full benefits of either approach.

As always your personal circumstances should dictate your approach.