Mortgages: To Fix or Not to Fix? Why is this a Question?
It seems every few months the media is posing the question:
“Are interest rates going to rise, and if so, is now the time to fix the interest rate on your mortgage?”
As this is such a pervasive question in our news cycle I thought I would offer a financial adviser’s perspective on why you may choose to fix your mortgage and if you were to fix it how would you benefit?
First of all, I’ll start with the question are interest rates going to rise?
I am happy to guarantee that interest rates will rise in the future, at some point (by how much and when I have no idea). I am confident in this as interest rates are at historic lows and sooner or later the RBA will be faced with rising inflation and their mandate will force them to raise the cash rate. While the cash rate and the mortgage rates are not perfectly correlated, an increase will flow through to a rise in variable mortgage rates.
If interest rates are going to rise does this mean that you would benefit from fixing now while they are low? Those who choose to fix do so because they fall into one of the three following groups:
You are unable to afford an increase in your mortgage interest rate as you would default on the loan if rates were to rise.
You think you are either smarter or have better information than the banks do about the future interest rates.
You are gambling
You are unable to afford an increase in your mortgage rate
If you are in the first group, the decision to lock in rates can provide you with some certainty. If you are in this situation you are also not likely to be impacted by the limitations on your ability to make additional repayments that come with fixed rates. having said that I would still be cautious about fixing; if your financial position further deteriorates and you are forced to sell your home prior to the end of the fixed period you will face break fees which could amount to many thousands of dollars.
You are smarter or have better information than the banks
I would argue that no one really belongs in this group. As of September 2016 the Australian Banks had $1.531 trillion of mortgages outstanding (Source: ABS). They have all of the available information about the Australian economy and the future expectations for interest rates. They employ economists to create and use all of this information for the purpose of incorporating it into the rate they offer for fixed rate mortgages.
You are gambling
If you do not fall into one of the above categories of people who are fixing, you are choosing to fix in the hopes of benefiting from the banks being wrong which is essentially gambling. As with all gambling, some people will win and others will lose but to evaluate the benefits of this gambling I have compared the average discounted standard variable mortgage rate against the 3-year fixed rate since June 2004 (when the data starts) until December 2016. To see whether fixing would result in a benefit I have determined the average variable rate experienced over the same three-year period as the fixed rate. This is plotted below:
Based on this, if you were gambling you would have won if you fixed between September 2004 and July 2006 and again briefly between Dec 2008 and May 2009. For 30 months out of the 115 between June 2004 and December 2013 you could have beaten the banks, however for the remaining 85 months (73% of the time) the decision to fix would cost you money.
Unfortunately, those who chose to fix at the wrong time were worse off by a greater amount than who benefited from fixing at the right time. In October 2005, you could fix for 6.55%. Over the following three years the variable rate holders paid an average of 7.57% so you had a better rate by 1.02%. If you managed to pick one of the 30 months where it would be better to fix, the average benefit of was 0.52% over the three years.
Conversely, if you were to fix in July 2008 you would have paid 2.98% more than the variable rate holders paid. In the months where it was better to be variable, the cost to fix was 0.92%. You had nearly twice as much to lose as you had to gain from fixing. Across the entire time frame those who fixed paid an average of 0.54% more than those with a variable rate.
For those facing financial and mortgage stress the decision to fix can offer you a greater level of certainty and potentially allow you the time to get your finances back on track without the risk of a rate rise, however for most people the decision to fix is based on a guess about the direction of interest rates and on average will cost you money.
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