Why You Should Think Twice About Fixing

Over the life of your loan, a variable rate will almost certainly prove cheaper than a fixed one. Here's why.

As speculation about rates intensifies, some people are considering fixing their home loan interest rate. But ask any economist and they will probably tell you that fixing your home loan interest rate seldom saves you money in the long run. Variable rates usually cost less over time.

The comparison isn't as easy as it looks, because you have to check what happened to variable rates in the years after you took out your loan. In particular, you have to ask: did variable rates spend most of their time below fixed rates, or above them?

For most periods, the answer turns out to be that variable rates spend the bulk of their time below fixed rates. The result is that variable rates usually end up being cheaper.

No-one can tell for sure what will happen to variable rates in the next few years. So as a borrower, you have to make a bet. And if you're only interested in the total cost of your loan, a variable rate is a more attractive bet. (But see the bottom of this article for circumstances where fixing makes sense.)

When fixing pays (answer: not often)

The ANZ Bank's economists have compared the costs of fixed and variable rates. And they found that over the 1990s, borrowers who fixed their home loan interest rate would have been significantly worse off than those who stuck with variable rates. The study, based on average fixed and standard variable rates between 1990 and 2000, found that there were only two brief periods when fixed rates turned out to be cheaper than standard variable rates:
* from late 1992 to late 1993
*from early 1997 to mid-1998

Fixed rates can leave you paying much more. In the early 1990s, many borrowers reeled away from the variables rates of up to 17 per cent seen briefly in late 1989 and early 1990; "Fixing your rate" became an extremely popular strategy. Many borrowers believed fixing would save them money. But over the next few years, those fixed-rate borrowers found themselves paying up to 3.5 per cent more in interest than borrowers with variable rate loans. The costs were huge. On a $200,000 loan, paying 8 per cent instead of 6 per cent for three years will cost you $9253 in extra interest.

"If we look at rate movements over the past several years, most of the time it was better not to fix," says ANZ Bank economist David Colosimo.

The result would have favored variable rates even more if the study had looked at cheaper so-called "basic" variable-rate loans, which lack some of the features found in "standard" variable-rate loans.

Understand the fixed gamble

Of course, the 1990s were an unusual decade: Australian interest rates fell further and stayed down longer than most people had expected. It may be that interest rates will surprise economists by rising over the next few years. If you believe that will happen, you may want to take out a fixed loan.

But your lender's fixed and variable rates are set in the professional money markets, which are full of people paid to understand rate movements. So if you're thinking of fixing because rates will rise, you may want to ask yourself: "am I more likely to know the future of interest rates than most of the professional money market players?"

Fixed rates can be good insurance

While deciding between a fixed or variable rate loan is primarily a financial decision, David Colosimo says borrowers should consider lifestyle and personal factors. "Choosing a fixed rate loan is an insurance policy as much as anything," he says. "When you buy an insurance policy you have certainty over that period. If that is important to you, then it's worth taking out the insurance offered by fixed rates." For instance, you may be on such a tight budget that you don't want your loan costs rising under any circumstances. In that case, a fixed rate may make sense.

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