Fixed VS Floating

Hey team,

Wow it is good to not be writing about Bitcoin. That’s 5 days of our lives none of us are getting back. Hopefully the matter has been put to rest, at least in the near term. And with that, let’s talk about something real. Let’s talk about interest rates. And fixed vs floating specifically. Why? Because the Aussie banks have just started a new round of interest rate reductions for fixed rate mortgages (see here) bringing the “to fix, or not to fix” question raging back into your Sunday morning brunching conversations.

Fixed vs Variable
In the simplest terms, if you fix your mortgage rate, you effectively lock in both the interest rate AND the repayments you have to make for a period of time. If you’ve got a variable rate mortgage however, both the interest rate the bank charges you AND the repayments you have to make can change.

In general, banks change their rates only when the RBA changes the official interest rate. And if you remember back to earlier this month (see here), the decision to do that happens on the first Tuesday of every month and usually in increments of 0.25%. So if the RBA were to change interest rates next month, those of you with a variable rate will see your interest and mortgage repayment amounts change, those of you who have fixed though, will not.

The motivator for fixed rates is certainty. It’s awesome for budgeting. You’ve locked exactly what you have to pay, every month, for however long you’ve chosen to “fix” for. The downside of this though, is you can’t pay any more than the agreed monthly repayment into your loan, even if you can afford to.

The single biggest advantage of a variable rate mortgage is flexibility. With a variable rate, the bank will give you a minimum monthly payment which you have to make. However, at any time, if you find yourself with a lazy couple of “hungies” you can throw that in as well, meaning you can potentially pay off your loan quicker. The downside though, is should interest rates start rising, your mortgage repayments will start rising too. And that can make it incredibly tough for budgeting. Particularly if you’ve already borrowed a lot more than maybe you should.

Some *yawn* maths
The interest rate banks quote you for say a 2 year fixed mortgage represents what it expects the variable rate to be “on average” over that period. For example, if the bank believes that the RBA is not going to change interest rates for the next two years, then the variable rate they quote you will be the same as the 2-year fixed rate they offer you. Make sense?

Right now a bank (which shall remain nameless) is offering 3.84% variable and 3.88% for 2 year fixed. What this means is that the bank thinks there is little chance the RBA will increase interest rates over the next two years. There’s a small chance, which is why the 2 year rate is slightly higher than the variable one, but that’s about it. That same bank is offering 4.19% if you fix for 5 years.

So, what’s the answer then? 
First, there is no right answer. Second, only in hindsight will you know you if you would have been better off fixing your mortgage or not.

Therefore, thirdly, the decision you need to make is whether flexibility or certainty is more important to you? Certainty of your payments, certainty of your budgeting, or flexibility to ship more into your mortgage whenever you want. In general, if you’ve “stretched” yourself, borrowing quite a bit and would find it challenging to make your repayments in a world where your mortgage rate is 1% higher than it is now, you should be thinking of fixing, at least for some of it. It just provides you a little bit of safety and protection. Safety first.

We’ll right more on this another time.

For now, that’s 5 minutes. Hope it helped.

Categories: Investing

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