Your Mortgage – To Fix or Not To Fix

Tom On Tuesday phoned his bank in December just before another anniversary arrived on the mortgage. So the question Shakespeare may have posed in this scenario is, “To fix or not to fix, that is the mortgage interest rate question.”

It seems that many people perceive that financial matters are full of difficult concepts. The difference between fixed and variable mortgage interest rates is one such topic.

A variable interest rate means that your financial institution can change your mortgage interest rate up or down at any time. However these changes are not entirely arbitrary.  The Cash Rate, set by the Reserve Bank of Australia, is the basis for changes in variable interest rates. The Reserve Bank changes the Cash Rate as a broad means of affecting the Australian economy. The Cash Rate is also the rate that banks lend to each other overnight.

YOUR variable mortgage interest rate is set by your bank at a margin above the Cash Rate. The Cash Rate since 3 November 2010 has been 4.75% pa. A typical variable interest rate at the moment is somewhere between 7.25% and 8.0%.

Fixed mortgage interest rates are a set rate for a period of between one and five years agreed between the borrower and the bank. Fixed rates are set by reference to banks’ borrowing costs. Fixed rates ARE NOT related to the Cash Rate.

So, which is better, variable rates or fixed rates? As with so many financial decisions, the answer is, it depends. In practice, most mortgages in Australia are on a variable rate. There are some exceptions, such as introductory or “honeymoon” rates where the bank may offer you a low rate for the first year to get your business.

Let me explain with some examples, relevant at January 2011.

Introductory/Honeymoon rate: 7.1% for first year

Standard Variable Rate: 7.7%

Fixed Rates: 1 Year 6.94%; 2 Years 7.19%; 3 Years 7.20%; 4 Years 7.69%; 5 Years 7.89%

So if you are some years into your loan, do you choose fixed or variable? The first thing to note is that the longer you fix, the more expensive is the rate. This is almost always true. Second, the one year fixed rate in this example is considerably cheaper than the variable rate. While that is true at this time of the cycle, it is not always the case. The one year fixed rate tends to be higher than the variable rate when interest rates are at the bottom of the cycle and tends to be lower than the variable rate as interest rates head towards the top of the cycle.

So where in the cycle are we now? No one knows for sure but here is a history of the Cash Rate as set by the Reserve Bank.

So how do I find the best rate for me now? Look here to check current home loan interest rates.

NOTE: Tom On Tuesday IS a CPA but is NOT a tax agent, a financial planner, a banker nor a stock broker. Please note that all blog posts written on financial matters should not be taken in any way as advice from Tom On Tuesday. This blog post contains general information and the opinions of Tom On Tuesday. This general information also only pertains to Australia. Anyone reading this blog should seek out professional advice for their own personal circumstances before making any decisions.

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