THE FACTS:
Over the past 29 years, you would have been better off only 30% of the time with a 3-year fixed rate over a variable rate.
Statistically, borrowers are terrible at choosing the right time to fix rates (especially when it may appear overwhelmingly better to do so).
The average loss from fixing rates is 5x the size of the average saving. This is because lenders have larger profit margins on fixed-rate loans. (This should not be confused with the risk premium paid for interest rate protection).
2.3% p.a. was the most significant increase in standard variable rates in any 3 years since 1990 (under RBA's inflation targeting monetary policy).
INSIGHTS:
The chances are that you will not save under a 3-year fixed rate vs a variable rate loan.
Be wary about lenders and brokers trying to sell you a fixed rate loan because it is good value for you. Given lenders' larger profit margin on fixed-rate loans, it is actually always better value for the lender.
Because of this and early repayment penalties associated with a fixed rate loan, we recommend that you should only go with a 3-year fixed rate loan over a variable rate loan if you think you will not be able to afford repayments in a worst-case scenario that interest rates increase by 2.5% p.a.
With sharp reductions in the 3-year fixed rates, many of our clients are asking us should they fix their home loan?
To provide you with some impartial science based advice on the topic, we have undertaken some statistical analysis which I typically share with my corporate and institutional clients. Hopefully, this provides you with some useful information to help you make a more informed decision.
We have looked into whether fixing your interest rate for 3 years would have resulted in a better outcome at any time over the past 29 years.
Based upon the last 29 years:
• 70% of the time, you would have spent more on interest; and
• 30% of the time, you would have saved on interest (See Chart 1)
We also had a look at whether borrowers, in general, have any ability to choose the right times to fix their mortgage rates.
The most significant period where borrowers would have enjoyed the benefit of fixing their interest rates was from 2008 to 2010. Interestingly, this was also a period where there was a noticeable reduction in the proportion of new fixed-rate loans vs variable rate loans. During this time, 3-year fixed rates were about 2% higher than variable rates and it seemed crazy to most people to fix at such a high rate. (See Chart 2).
Similarly, in 1995 when 3-year fixed rates were around 1% lower than variable rates, many borrowers thought that fixed rates were better than variable rates. In fact, variable rates over the next 3 years reduced well below the fixed rate and it would have been better to have had a variable rate loan.
This suggests that most borrowers do not have the ability to successfully pick the right time to fix their mortgage. In fact, when more borrowers think it is a good time to fix their rates, it usually means it is NOT and when more borrowers think it is not a good time to fix rates, it usually means it is.
We also looked in the average size of interest savings and losses. Over the past 29 years:
• the average loss was 0.75% p.a.; and
• the average saving was only 0.15% p.a. (See Chart 3)
This suggests that the potential benefit of fixing your interest rate is significantly smaller than the potential loss.
To explain why this is the case it is worth understanding how lenders make more profit on fixed-rate loan. Lenders won't tell you this. After all, it is not in their interest to be transparent. We've acted for large corporate borrowers who don't let the banks get away with it, and we will spill the beans on how they do it.
Banks borrow most of the money they lend (~90%). Some of this comes from deposits, but a lot comes from the wholesale capital market. The wholesale capital market charges the banks a Wholesale Borrowing Rate and banks add a mark-up that results in the Retail Lending Rate to consumers. You can think of this as being similar to how a retail shop charges a mark-up on the wholesale price of the goods they sell.
The wholesale capital market also offers banks variable and fixed Wholesale Borrowing Rates. The fixed rates offered by the wholesale market are partly dependent on market views on future interest rates. If the market view is that the RBA will increase rates in the future, fixed wholesale rates will be higher, if the market views that RBA will reduce rates in the future, the wholesale fixed rate will be lower.
Now, banks never tell consumers their mark-up, but generally, the mark up is significantly larger on fixed rates. Because of the significantly higher mark-up, fixed rates are disadvantaged at leading to a better result than variable rates.
As at 8 April 2019, the wholesale 3-year fixed rate was a lot lower than the wholesale variable rate and the banks' mark-up on fixed rates is 50% greater than on variable rates. (See Chart 4).
Of course, if after hearing this you are happy that the banks make more money because it gives you peace of mind that is fine. However, if you hear a broker or lender trying to sell you a fixed rate loan because it is 'good value', you should know that it is actually even better value for the lender.
To give a sense of a worst-case scenario of rising interest rates, 2.3% was the largest increase in variable rates in any 3 year period since 1990.
Conclusion
Despite how attractive fixed rates may seem compared to variable rates, our general advice is that deciding to go with a fixed interest rate loan should not be based upon your expectation of future interest rates.
Deciding to go with a 3-year fixed rate loan should be based upon your own personal circumstances and your ability to make repayments if interest rates increase. We suggest you ensure you can make repayments in case interest rates increase by 2.5% p.a. If you have trouble making repayments in this scenario, then you should consider a 3-year fixed rate loan.
View our fixed and variable home loan rates on our Rates Finder page.