To Fix or Not To Fix?
By Bill Zheng

In recent months there are many questions that I have been asked continually. The ones that seem to be on everyone’s lips are about interest rates, what are they are likely to do and what, as investors, should we be doing about them.

Interest rates have fallen considerably over the past six months with the official cash rate now at 3.25%. Many investors will now find their investment properties neutrally geared if not positively geared. This situation is,  indeed, in stark contrast to the previous 10 years when the majority of investment properties were negatively geared.

The question most commonly asked is - should I fix my interest rate and if so when is the best time to do it.  Unfortunately none of us own a crystal ball, but we do have is historical data and the ability to analyse this to forecast future trends.

Why You Should Consider Fixed Rates Now?
Mortgage industry research over the past 27 years reveals that 83% of the time, the borrower with the variable rate loan was better off than the borrower with the fixed rate.
 
Having said that, fixing your interest rate does have numerous advantages, especially in today's climate.  The current low interest rates are likely to be of the “once-in-a-lifetime”.  Generally the best time to fix is when the interest rate cycle is close to bottoming and when the prospect that cash rates will increase in the near future. 
 
In my opinion, borrowers should start considering their options now.  With the government trying to boost the economy through various stimulus packages, we will get to a stage where it needs to ensure inflation is kept in check. To do this, the RBA will probably increase the cash rate. If the stimulus packages works as intended it will have an inflationary effect, which in turn will lead to an increase in cash rates.
 
If you’d like to know exactly how much you’ll be paying out from month-to-month without having to worry that your repayments may increase, then fixed rates are for you.  For investors, it is a promising situation to have the comfort of locking your fixed rate and the certainty of a positive or neutrally geared property for up to five years.
 
Given that interest rates are at historic lows and rental yields are continuing to climb amid low vacancy rates. Because there is strong rental demand, now is a great time to be fixing your interest rates.

The downside to fixed-rate loans is the fact that you can be locked into a higher rate while variable rates are cut. To avoid putting all your eggs in one basket, the other option would be to have a bit of both, by splitting the loan and having one portion fixed and one portion variable.

Fixed-rate Strategies
For core properties that are earmarked for long-term hold, investors should look at fixing for a minimum of 3 years preferably 5 years as long as the property cashflow can be maintained at a neutral or better position. Ideally investors should stagger the duration of their fixed rates to ensure they don’t all mature at the same time. Staggering the duration of fixed rates ensures the portfolio isn’t fully exposed to the current variable/fixed rate at expiration of fixed rate agreement.

It is also important to keep in mind discounts and specials on fixed rates when they are on offer. These discounts are a relatively safe way for lenders to attract your business because refinancing during a fixed term is rare.

If you do decide to go for a fixed rate loan, the next question you face is how long do you wish to fix your loan for?  The most common fixed rate terms are 1-5 years, with some institutions also offering terms up to 10 and even 15 years.  Right now, the shorter the fixed period, the lower the rate. This says to me that bank's are aware that rates won’t stay low for too long.

Personally if I could get a fixed rate loan for 3-5 years at about 5% and I thought we were at the bottom of the cycle, I would be fixing my loan. Historically over the past 30 years interest rates have averaged around 9-10% p.a.  Again, for property investors, an interest rate around 5% for up to 5 years could mean a neutral or positively geared property for the long term.

So What Influences The Fixed Rate Market?
Well contrary to public opinion, fixed rates are not solely influenced by the Reserve Bank of Australia (RBA). Rather, they are also influenced by those who invest in the fixed-rate wholesale markets. Imagine if you had a store that sells nothing but this new `must have product` called three-year-fixed. As with most supply and demand economics, the store weighs up the price versus the demand. Sure this is a very simplistic analogy, and there are many other factors that influence the price but an appropriate example nonetheless.

Fixed rate loans are largely funded by money raised by lenders in global financial markets, plus a retail margin, plus a margin for risk.  Variable rate loans on the other hand are influenced by the official cash rate set by the RBA plus a retail margin added by the bank.

The RBA cash rate target has historically been the benchmark for setting wholesale mortgage rates in Australia. Therefore, consumer mortgage rates are generally priced at a premium over the cash rate, reflecting the borrowing rate between the RBA and lenders plus a risk margin for lending funds to consumers.

Recently, we have seen lenders move their variable rates outside the official RBA movements, and doing so when the cost of providing funding increases. Obviously the reverse also holds true - which applies to fixed- rates as well.

Exit Fees
There are many reasons investors are nervous about fixed rates and one of these is the exit fees/break cost. So how are these calculated?

An exit fee is a one that is charged by lenders when you repay your loan before its expiry date. For most lenders, this fee is applicable if the loan is repaid in full either in the first, second, third or fourth year.

It can either be a flat fee charged or a percentage of the original loan amount - depending on the lender.

Fixed-Rate Break Costs
The break costs is a fee charged by lenders when you either make extra repayments on a fixed rate loan, or repay the loan entirely before the expiry date.

Most lenders allow you repay a small amount of your fixed-rate loan, but exceeding this incurs break-cost fees. The number of extra repayments that a lender allows you to repay will depend on which lender you are using. Given that lenders often change their policies from time to time, you should also check with the lender how much extra repayments you are entitled to make without a break cost being applicable.

Different lenders use different names for break costs, some of those used by some of the major lenders are:

• Westpac Banking Corporation    “Break Costs”
• Australia & New Zealand Bank    “Early Repayment Fee”
• National Australia Bank              “Prepayment Fees and Economic Costs”
• Commonwealth Bank                 “Early Repayment Adjustment”
• St.George Bank Limited             “Break Costs” 

How Lenders Calculate Break Cost
Lenders calculate break costs by working out the difference between the wholesale rates from the time you applied for the loan to when you would be repaying it, multiplying it by the loan amount and the remaining term of the loan.

There is no standard formula. Each lender has their own specific method of working out their break costs. Each lender should detail a formula for calculation in their fixed-rate loan contract. For example:

Break cost = Loan amount x Remaining fixed interest rate term x Change in wholesale rate

If interest rates have increased since the time you fixed your loan, you may not be charged a break cost fee for breaking your fixed interest rate contract, because the lender would actually make money out of you breaking your contract. Despite this, however, some lenders may still charge you a fee, clarify this with your specific lender.

Break cost calculation example
Mr John Smith has a $500,000 loan with “Bank Limited” which he locked in to a five-year fixed Interest rate of 7% p.a..  After the first 2 years, John requests to break his fixed-rate contract.

The wholesale rate has dropped by 2% since the time John entered into his fixed rate contract.

The Break Cost to John would be as follows:

Break cost = Loan amount x Remaining fixed interest rate term x Change in wholesale rate
Break Cost = $500,000 x 3 years x 2%
Break Cost = $30,000

It is important to note that the above calculation is an example only, and you should refer to your fixed rate loan contract and/or your lender for an accurate break cost calculation.

Generally speaking, the biggest problem with fixed-rate products is they are not flexible. When we talk about fixed term, the usual time period may range from three years up to 10 or even 15, during which, someone’s financial position can change dramatically.

An ideal fixed-rate product would be one that has the best interest rate, and lets you put in or take out as much as you want, while allowing for revaluation, top-ups and minimal break fees if you refinance. Unfortunately, like most things in life, you don’t always get what you wish for. Go for the product that meets your immediate requirements (for most of us, it’s a good interest rate for a defined term) but don’t forget to keep in mind the things that are important today may be worthless tomorrow.

Personal situations play a major role in finance strategies, and the same thinking applies to optimum length of fixing. From a financial perspective, the main factors to consider when deciding the optimum term length are the best interest rate and predicted movement of the variable rate over the fixed term.

In a nutshell, the optimum term largely depends on individual situation and need for flexibility in certain time period. From financial point of view, 4-5 year terms are providing better yield than others, but may change as the fixed-rate market is predicted to move with the variable in market in the forthcoming time.

I would like to thank my team of Mortgage Strategists at Investors Direct for their expertise and contribution to this article.

This article was written by Bill Zheng, founder of Investors Direct, an award winning Mortgage Company specialized in strategies and finance for residential property investors since 2001.  Investors Direct is the finalists in the 2008 Australian Mortgage Award for Brokerage of the Year (Over 12 Staff Category) & Best Customer Service from an Individual Office.