Fixed vs. Variable Interest Rates
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It’s often written that when deciding whether or not to fix your property loan interest rates you should be very careful as banks will make money out of your loan regardless of whether you fix or not, and that statistically the majority of times when people fix interest rates they end up losing money compared to their position had they remained on variable interest rates.
While it is probably true that banks will make money on your loan regardless of what you decide to do and those statistical figures may be correct, this is in no way any reason for people not to fix interest rates in any situation – as long as the reasons for doing so are very clear.
So what then is the main reason to fix interest rates?
In our view this is to mitigate risk, specifically the risk of increases in variable interest rates that may put your capacity to service the loans on the properties you hold at risk.
This is one of the biggest risks that property investors need to manage.
And while this may not be such a big issue if you have one or two properties or only a small amount of loans relative to your capacity to service those loans, once you have several properties and a seven figure loan balance interest rate risk becomes far more significant.
In this instance a large increase in variable interest rates on a large loan balance over a period of time may eclipse your salary or business income, and doing a few extra shifts at work or working a bit harder in your business may not be enough to cover this extra cost.
Having said this though, you also need to be aware of the two key risks of fixing interest rates.
The first risk is that by fixing interest rates you usually lose any 100% offset account feature on your loan (one exception to this we are aware of though is with Adelaide Bank) – this is important if you are paying down your home loan by putting money into your offset account, or are intending to pay off any investment property loans by doing this too.
Putting money into loan redraw facilities is limited too, with most banks only allowing you to put a very small amount into redraw.
The second risk is that once you fix interest rates you are basically locked into the loan contract with that particular bank and you generally cannot re-finance the loan to another bank without incurring significant break fees – so if you think there is any chance that you may want to sell the property then you may be better off staying on variable interest rates.
There are however some situations where breaking a fixed rate loan may not incur large break fees, eg. when variable rates are higher than the rate you fixed at (it’s actually a bit more complicated than this as it is more accurately to do with the banks cost of finance when you signed the fixed rate loan contract and their cost of finance today, and a few other variables) – but even in this situation it’s almost impossible to predict exactly what the break fees will be so we don’t suggest you rely on this situation to get you out of a fixed rate loan.
From a practical perspective it’s also worth noting that to secure a particular fixed interest rate at a point in time you will need to pay a “rate lock” fee, the cost of which will vary depending on the bank, though some banks may refund this fee after the loan has settled.
The next question then is when should you fix interest rates?
This is a much debated question and is difficult to answer as it’s very hard to predict exactly when fixed interest rates are at their lowest point in the interest rate cycle.
Before asking this question though, we feel you are better off asking when should you NOT fix interest rates, as we feel that most people get into trouble with fixed rate loans by not having an awareness of this.
When variable interest rates are above long-term averages (around 6.5% p.a.) and interest rates are rising, we suggest that you be very careful about fixing interest rates, and if you do, then only do so for one year at the most.
Just as it’s hard to pick the bottom of the interest rate cycle, it’s also hard to pick the top, and locking yourself in for a 3-5 year fixed rate term just before interest rates start going back down again will leave you with 3-5 years of financial and emotional pain, so be very careful of fixing interest rates at these times!
On the other hand, when variable interest rates are below long-term averages, interest rates have fallen substantially, and fixed interest rates appear to be close to historical lows, then the risks of fixing interest rates for 3-5 year periods are much less.
For 3 year fixed rates, 4.99% was the historical low point noted during the Global Financial Crisis (GFC), with 5 year fixed rates around 5.5% at the time.
Today it’s possible to get 3 year fixed rates as low as 5.09% and 5 year fixed rates as low as 5.45% with the major banks, and even lower with some of the smaller lenders.
Asking your current lender to match a lower interest rate offered by another bank is always a worthwhile strategy too.
In our view when 3-5 year fixed rates are around 5% to 5.5%, it is a reasonable time to fix interest rates.
Having the certainty of what your interest payments are going to be for the next 3-5 years is a great way to reduce a significant risk of having several loans.
This will also allow you to plan your future investments with greater certainty and confidence, and potentially allow you to purchase more investments sooner than you otherwise would have had you stayed on variable interest rates and had to plan and budget for the cost of unknown and unpredictable future interest rate increases.
With this in mind, it should not matter to you then if you fix interest rates at say 5.09% for 3 years, and 3 year fixed interest rates fall to 4.79% six months later, as you have had the benefit of certainty of interest payment for six months – which you can’t necessarily quantify.
It’s human nature of course to want to get the absolute lowest interest rate possible and hold out for something better, but in doing so you also take the risk of missing out on a good interest rate all together as when fixed rates move up they tend to move up very quickly.
We suggest that getting close to the bottom of the interest rate cycle and fixing interest rates then is a much better approach than trying to pick the absolute bottom.
Our approach has been to fix about 50% of our total loans and leave the other 50% at variable interest rates, but you could fix more or less of your loans depending on your individual situation.
And when starting to fix loans, fixing a portion of your loans at the best current fixed interest rate and then waiting a few months before fixing the rest is another strategy you could use to hedge your bets and potentially get some of your loans at a lower fixed interest rate – but again the risk here is that fixed interest rates move up rather than down while you wait and those loans can then only be fixed at much higher interest rates!
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