Are you rate-sensitive?

A rate-sensitive loan borrower in front of notebook

As a borrower, you are considered rate-sensitive if you will become financially stressed should the interest rate of your loan increase. In general terms, the range for an increase that would result in stress is 1–2 percent.

Borrowers on a low income or a fixed income often need a known, consistent repayment amount so they can budget for it. If you are rate-sensitive, you should consider a fixed interest rate. These types of loans guarantee the rate will not change during the fixed term.

However, fixed rates can be a double-edged sword, as you may fix at a rate which, due to later market conditions, is higher than the current variable rate. There is always the option of splitting your loan so that part is fixed and part is at a variable rate. This provides flexibility and allows additional repayments of principal.

Should you fix

A common question people looking for a new loan ask is, “Should I fix my interest rate?” The answer is not simple. First, you need to understand that fixed rate loans have exit fees, which can be very costly if you repay the loan before the end of the fixed rate period. You should first consider: Are you rate-sensitive? If you really need a fixed rate, that may be a good idea, but only if you answer no to the next two questions.

  1. Will you move in one to three years? If you think you may have to move in the short term, you should look carefully at the exit costs of the loan. You should consider a variable interest rate loan with no break fees.
  2. Will you be able to make any additional repayments? If you think you will be able to make extra or lump-sum repayments, it’s a good idea to avoid fixed interest rate loans, which may charge you penalty fees or break rate fees if you pay more than the agreed-on repayments. Let’s look more closely at why fixed rate loans can be a double-edged sword for borrowers.

When it’s good, it’s good.

If you chose the right time to fix, you can win. For example, if you fixed for three years in July of 2004, you would have had a rate of 6.95 percent when the standard variable rate was 7.05 percent. In the following three years, the standard variable rate increased, peaking at 7.45 percent. Your three-year fixed rate would have always been less than the variable rate!

When it’s bad, it’s bad.

If you chose the wrong time to fix, you lose. For example, if you fixed for three years in July 2008, you would have had a rate of 9.4 percent when the standard variable rate was 9.6 percent. In the following months, the reserve bank reduced interest rates to thirty-year lows. In April 2009, the standard variable rate had dropped to just 5.75 percent! At no time during the three-year fixed period would your loan have been at a rate lower than the standard variable rate, and for long periods you would be paying more than 3 percent above the standard variable rate. Some economists believe that the “normal” variable rate is in the 7–8 percent range.

Therefore, any fixed rate less than this should, over time, be lower than the variable rate. However, this is based on averages over the last twenty years. In the last five years, we have seen the variable rate swing from a high of 9.6 percent to a low of 5.25 percent.

We have entered a period of global financial uncertainty. I believe it is even harder now to predict interest rate changes and when to fix your loan . It’s simple. You can’t see into the future to know if you will be better off.

A lot of people have fixed at the wrong time and paid for it. So don’t enter into a fixed rate expecting to win every time.

Sometimes you will win; sometimes you will lose. Enter into a fixed rate if you’ll be happy to pay the interest rate for the whole fixed period, regardless of what happens to the standard variable rate.

Some lenders offer fixed rate loans for periods up to ten or fifteen years. Generally, the longer the fixed rate term, the more likely you will be paying more than the variable rate. I would never fix for a period greater than five years. I have only fixed once. I got what I thought was a good rate fixed for three years.

For the first year I was well ahead, then the variable rate turned downward, and by the start of the second year I was paying well above the variable rate. In the end I think I came out about even, but I lost the opportunity to pay down my loan when the rates were low. As a result, I have never again fixed the full loan balance. I would consider fixing part of the balance for short periods of, say, three or less years.

So what do most people choose? While exact statistics are not available, it’s generally believed the residential loan market is broken into the following product and interest rate categories:

  • Variable interest rate loans (principal and interest repayments): 80 percent
  • Variable interest rate loans (interest-only repayments including line of credit): 14 percent
  • Fixed interest rate loans (both principal and interest and interest only): 6 percent

Basic or Full-Featured Loan: Which should you go with?

Will you need a flexible loan? Will you make lump-sum repayments and then need to redraw the money? If yes, avoid the basic products with limited features, as an upgrade will usually entail expensive fees. Fully featured loans offer the option to split some or all into fixed rate or line-of-credit products. I’ve never been a fan of basic loans, even when the rate is less than full-featured loans.

I have found you need to keep your options open, and a basic loan removes options and charges fees and costs to add them back. If you choose a full-featured loan and find you don’t need the features, some lenders will allow you to downgrade to a basic loan — again, for a fee!