With the Reserve Bank of Australia (RBA) cutting the cash rate to 0.10% on Melbourne Cup Day, you may be asking yourself ‘Is now the right time to fix my mortgage interest rate?’
The answer depends on personal circumstances, such as your cash flow, family situation and employment status, and your current mortgage arrangements.
If you already have a fixed-rate mortgage, then your mortgage payments will not have changed because of the last interest rate cut nor any future reductions. If you are on a variable rate, then you may have seen a drop, though this is at the discretion of the lender. So far, few banks have passed the benefit of the rate cut on to existing borrowers.
Whichever type of mortgage you are on, it makes good sense to review your financial position and consider your options.
What are the benefits of fixing your mortgage interest rate?
One of the biggest attractions of fixing your mortgage interest rate is the certainty it provides to your monthly payments and financial plan.
With the interest rate fixed for a specific period, repayments will remain the same throughout the period irrespective of any changes in inflation, future interest rate expectations or the RBA cash rate.
At the end of the fixed period, the interest rate will typically revert to the standard variable rate, based on market interest rates at the time.
Fixed rates vary from term to term and, generally speaking, increase with the length of the fixed term. This is not always the case, however, with 2 year or 3 year rates occasionally lower than variable and 1 year rates. Rates also vary from bank to bank, depending upon each bank's funding position and commercial objectives.
These variations can create opportunities for borrowers to benefit from both lower interest costs and more certainty, where their personal circumstances allow.
What are the risks of fixing your mortgage interest rate?
Fixing your mortgage interest rate exposes you to potential implicit and explicit costs.
Interest rates may fall further after you fix your mortgage interest rate, which means that you may be paying more than you would have if you had stayed on a variable rate or set your rate for a different term.
If you decide to refinance or repay your loan during the fixed-rate period, you will likely incur explicit bank charges. These ‘break costs’ typically consist of:
- An administration fee. The amount varies by lender, and the borrower may be able to have this waived or reduced.
- An economic cost incurred by the bank to unwind the fixed-rate loan, which is passed on to the borrower.
The calculation of the economic cost varies from lender to lender. If interest rates have moved down during the period to date, the bank suffers an opportunity cost as they will no longer receive the agreed, higher rate of interest. If the bank has borrowed or otherwise hedged to manage the interest rate risk borne by providing the fixed-rate loan, the bank suffers an actual cost to unwind this financing. Either way, the borrower is required to compensate the bank for the costs incurred by breaking the agreement.
A typical formula for calculating the economic cost is:
(A - B) x C x D
where,
A - Bank funding cost at the start of the fixed-rate period for the full-term
B - Bank funding cost at the date the fixed-rate is broken for the remaining term
C - Loan amount outstanding
D - Remaining years in fixed-rate period
Example
Jenny borrowed $500,000 at 4.00% pa for three years when bank funding costs were 3.00% pa for three years. Jenny contacts her bank to break the loan after one year, with $500,000 still outstanding. Bank funding costs for the remaining two years have fallen to 2.00% pa. The bank has waived the administration fee.
Jenny must pay the bank $10,000 in break costs, calculated as:
(3.00% - 2.00%) x $500,000 x 2 years
How can you manage or minimise these risks?
Before fixing your mortgage interest rate, you should consider your current and future cash flow position. As with investing, you should be confident that you can commit for the intended term, to minimise the risk that you will need or want to break the arrangement.
Some questions to ask yourself include:
- Am I likely to want or need to sell the house (or other security) during the fixed-rate period? If so, is the fixed-rate arrangement portable?
- Am I currently meeting or exceeding my contracted repayments? If exceeding, by how much? Is this likely to increase? Decrease?
- Do I expect to receive any large cash inflows that I may want to use to repay the mortgage?
- Am I likely to need to fund a large expenditure or expenditures during the fixed-rate period? e.g. new car, education costs
- Do I have a sufficient cash buffer or cash on hand to continue to meet the fixed mortgage repayments if there is a reduction in my income?
- Do I think that interest rates may fall further during the fixed-rate period, and how will I feel if they do fall after I fix my mortgage interest rate?
Once you understand your current and likely future cash-flow position, you can consider structuring the loan/s to align with your needs and minimise risk.
For example, you might ‘ladder’ the maturities to match your expected overpayments, while keeping part of the loan on a variable rate to maintain flexibility.
If you leave a portion on variable, you will need to be comfortable that your finances can withstand any rise in interest rates during the period of your mortgage.
Example
Jenny has broken her fixed-rate loan and is now considering the current interest rates offered by her bank.
- Variable Rate 2.29%
- 2 Year 2.39%
- 3 Year 2.29%
- 5 Year 2.79%
Jenny doesn’t think that interest rates have much further to fall and can comfortably service the loan at current levels. She has a year of income saved, and estimates that she can pay an extra $10,000 off her loan each year. In two years, she expects to receive $50,000 (after-tax) from the sale of an investment property she owns with her brother.
Jenny decides to split her loan into various maturities, as follows.
- Variable Rate $100,000 (savings held in an offset account)
- 2 Year $50,000 (matched with the expected receipt of the investment property proceeds)
- 5 Year $350,000 (core debt expected to be outstanding in 5 years time)
By 'laddering' the loan into various maturities, Jenny has protected $400,000 of the loan against rising rates for the next five years (with $50,000 repaid in 2 years). The variable loan with offset gives her some flexibility to reduce interest costs by making overpayments or saving in the offset account, while potentially benefiting from lower rates if they do indeed fall. Jenny may be able to make a limited amount of overpayments each year to the fixed-rate loans, which would be beneficial if the spread between the variable rate and fixed rate widens.
What should you do now?
For advice on your specific mortgage and its suitability for your circumstances, speak to your bank or mortgage broker.
If you would like to discuss your overall financial strategy, including investment, debt and risk management, we would be delighted to assist you. Please contact us on (03) 9013 6262 or via our website for a no-obligation initial discussion.
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The information on this website contains general advice which does not take into account your personal objectives, financial situation or needs. You should consider whether the information and any general advice provided is appropriate for your personal circumstances and where uncertain, seek further professional advice before taking any action.
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