Fixed v Variable…..Why you should never fix your home mortgage.
Have you locked-in the rate on your home loan?
Maybe you’ve ‘hedged your bets’ and have half of your mortgage on a fixed rate and the other on a variable rate?
Or maybe you’re undecided and wondering if you should or could lock it in and when, or how?
You’re getting advice from your parents, your friends and the nice lady at the bank, but knowing none of them are experts, you’re still left scratching your head.
You’re still thinking “Should I fix my mortgage?”
You might even be the type of person who doesn’t care all too much whether it’s fixed or variable, but you’re just curious as the question ponders now and again in the back of your mind and you’d like to put a stop to it once and for all.
We’ll, this is how I see it.
You may agree, or disagree, but either way I’d like to hear what you think after reading my views.
Chris’s Theory on Fixed vs Variable Mortgage Rates
In general, our mortgages and loans are obtained from a bank, credit union or building society.
We refer to them as lenders.
If you saw a loan broker or mortgage broker, they didn’t give you any money, they simply sourced the best loans available from those on offer from the lenders and was paid a commission from the lender for referring you to them.
So, why do lenders lend?
Lenders lend as a fairly secure way of making a return on their money. It’s akin to us putting money in a saver account or fixed term deposit. In this case, we are lending to the bank in exchange for a return on our money.
Therefore, can we agree that the reason lenders lend is to make money?
Okay, now we need to ask the question why lenders offer both fixed and variable rates of interest.
Let’s start with variable. This is the easy one.
Banks get the money to lend using a large portion of the money that you or I have deposited with them. They also have the ability to borrow from other banks.
With a variable home loan rate, all they need to do is charge you a higher interest rate than what it is costing them and the difference is their profit. If their cost of borrowing increases then yours will too.
For example, if you have $20,000 of your money in a savings account paying a rate of 2.5% p.a., it is likely that the bank is lending this same $20,000 out to someone else (or even you!), in the form of a loan, at a rate of 4.5% p.a. If your savings account rate increases to 3.0% p.a., the rate on someone’s loan will increase to 5% p.a.
Variable rates are easy for banks to control, because they know they can alter the rate on the mortgage when their cost of borrowing increases – maintaining their desired profit margin.
How do fixed rates work?
Firstly, it’s important to remind ourselves that lenders lend money in order to make money.
Let’s not forget that.
So, if a bank is able to exercise a high level of control on a variable interest rate i.e. they increase rates as their cost of borrowing increases, then why would they offer you the ability to lock the interest rate on your loan? It sounds risky to the bank, because if their cost of borrowing increases significantly, they would be unable to increase your fixed rate, which could result in them losing money.
But as we know…. Banks aren’t that stupid.
The reason banks offer fixed interest rates is for two main reasons:
- There is a demand for it – people like the certainty and convenience of knowing exactly what their repayments are going to be, so that they can budget for them accordingly.
- When interest rates are low, people think that they will be saving money over the following few years compared to having a variable rate on their loan.
Let’s address these two points.
Firstly, locking-in an interest rate so that you have the certainty and convenience of knowing what your repayments are is a benefit to you, not the bank. Therefore, you’re going to pay a premium for that convenience. Just like how you would pay more for a loaf of bread or carton of milk at your local store than you would at the supermarket – because it’s convenient.
Now the second point.
Banks employ a lot of smart people who predict future interest rate movements. If they think that the average interest rate over the next three years is going to be 5% p.a., then the interest rate they are going to charge you on a 3-Year fixed rate loan is going to be 5.5% p.a. to give themselves some room for error and stack the odds highly in their favour. After all, they’re the ones providing you with the convenience of locking-in your rate.
Don’t get me wrong, occasionally the wicked smart bank people will get it wrong and you will ‘win’, but just like roulette at the casino, the odds are stacked against you.
What do you think?
Are you still thinking “Should we fix our mortgage?” Or have you made up your mind?
Leave a comment below.