Interest Rates - fixed vs variable

Many home buyers are opting to lock in mortgage rates in favour of having the Reserve Bank decide their fate.  After numerous rate rises this may seem the obvious choice - but will buyers lose in the long run?

When taking out a home loan, borrowers are presented with an option of a fixed rate, a variable rate or a split rate. A loan with a fixed rate is taken out for a set period at a set interest rate. Variable rates fluctuate in line with market forces, and a split rate is a combination of both.

November 2006 saw interest rates achieve an eighth consecutive rise since May 2002. The Reserve Bank of Australia (RBA) was forced to make a 0.25% hike when its cash rate target increased from 4.25 per cent to 4.50 per cent.

A trend like this doesn’t auger well for struggling mortgagees but some experts are forecasting the end of the upward momentum.

CommSec equities economist Martin Arnold is predicting that the RBA's next rate move will be down.

"We believe that interest rates have peaked," he told the Sydney Morning Herald last month, adding that interest rates would likely remain at the same level in the near-term.

By locking yourself into a set rate you are gambling that rates will rise in the near future as a fixed rate is usually set slightly higher (about 0.5%) than the variable. If the market rate falls, borrowers are likely to miss out on the benefits of possible interest rate cuts over the next few years.

Let’s take a case in point. In October 2005, the big banks were offering three-year fixed rates at 6.5% (the standard variable rate was 6.1%) If you were to take out a $20,000 loan for three years at 6.5% you could expect total interest payments of $2,067.28 (assuming you paid off the entire loan in that period). If you’d taken the variable rate beginning at 6.1% and reaching 7.5% at the end of the three year period, you would have paid $2,046.69. Not a huge difference but it can make for big savings over a longer term. With interests rates predicted to stabilise and even fall it may be worth considering a split rate to cover any unforseen change.

Ultimately, the decision should be made by taking into account your situation and your own financial priorities. Expert predictions are really just educated guesses and it is impossible to forecast which direction interest rates will move in the mid to long term. Choose your rate by taking into account your income stream and need for security or flexibility.

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