Fixed Rate Loans

Fixed-rate loans go in and out of vogue in accordance with how people see trends in the interest rate market. A fixed rate can be a haven for people who fear rising interest rates and can also be a gamble for those who maintain a neutral view or who think that rates might drop.

A fixed rate home loan should only be chosen after careful consultation and advice from either a mortgage professional or financial adviser. Either way however, history shows us that even experts get it wrong and even the most audacious adviser is unlikely to make a recommendation on a fixed rate.

But before we talk about how fixed rates are determined we should have a look at the intricacies of fixed-rate loans and what they mean for a borrower.

Here are the characteristics of fixed-rate loans you should know about.

A fixed-rate home loan is really a contract between a lender and borrower taken out within the overall scheme of a mortgage arrangement. In other words it is an agreement between the 2 parties as to what rate shall prevail on the loan for a given period of time.

Most banks offer 1, 2, 3, 4 or five-year fixed rates. The major retail banks also offer fixed rates up to 10 years, and in rare cases even longer.

In Australia 99% of fixed-rate home loans are between 1 and 5 years.

Once a fixed rate has been agreed upon by both parties, it is not possible to break out of the contract without termination fees come into play. The method by which a payout figure is determined is contained in the fixed-rate loan contract and it is a complex formula that needs separate explanation.

A fixed rate gives you peace of mind knowing that your monthly commitments will not change irrespective of variable rate changes in the marketplace.

A fixed-rate loan is a good choice for people who expect changing income levels, for example following the birth of a baby or where one partner decides to embark upon a long-term period of education resulting in lower family income. The peace of mind you get from knowing that your monthly repayments are locked in makes it easy to budget.

If you want to make extra repayments, banks place a limit on the amount so be careful not to lock yourself into a facility with restrictions that could really cost you more money.

What happens if the fixed rate contract is terminated?

If a borrower decides to sell a property, refinance with another bank or simply opt to change from a fixed-rate to a variable rate, there will be termination fees payable. The fixed-rate loan contract will contain the formula as to how this amount is calculated and it is impossible to give a definitive answer here. Suffice to say that if, at the time the fixed-rate contract is terminated, the prevailing variable interest rate is higher than that fixed-rate, the fee will be quite low and quite possibly zero.

If on the other hand the prevailing variable interest rate is lower than the fixed-rate, the fee could be high and the larger the difference between the fixed-rate and the prevailing variable interest rate is, the higher the fee will be.

Examples experienced by some borrowers during the global financial crisis starkly highlight this issue.

Look at this example.

A borrower had taken out a $300,000 loan to purchase a new property in mid-2009. The prevailing variable interest rate was 7.8%, but the borrower decided to take advantage of a five-year fixed rate home loan with an interest rate of 7.5%, believing that rates were on the rise.

6 months after the onset of the global financial crisis the variable interest rates had plummeted to 4% and the borrower sought to change from a fixed-rate to a variable rate to take advantage of the lower repayments. Given that the borrower was paying $2097.64 a month for the fixed-rate loan and that the variable rate loan would have meant monthly repayments of $1432.25, it is easy to understand the motivation to change.

But when their termination fee was calculated, the bank determined that the fee would be just over $33,245! This proves the point that where the prevailing variable interest rate is lower, but greater the difference between that and the fixed-rate, the greater the fee. Naturally, the site could not afford to make the change and was forced to keep paying the higher fixed rate.

This simple example highlights some important considerations that should be given to taking a fixed-rate home loan.

Make sure you get professional advice before making a change to a fixed rate.

Work out a worst-case scenario similar to the above and see whether you are prepared to live with the consequences of your decision.

Breaking a fixed rate involves paying early termination fees and the greater the difference between the rates and the longer the time left on the fixed term is, the higher the fee will be.

Consider taking shorter term fixed rate home loan in order to offset the possibility of the variable rate dropping to much lower levels.

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