Mortgage: Change To Fixed Rate or Keep It Variable ?

The rule of thumb for mortgage is to fixed the rate if it’s going to go up and keep it variable if it’s going down. As a mortgage holder (definition: the one that has a lot of debt to the lender), of course we want to pay the smallest amount of interest. Especially if the mortgage is on our own home (not on investment property) because usually we won’t get a tax benefit from it. After all, mortgage interest is not giving us any added value, it’s just income for the lender as their reward to lend us the money to buy the property.

During 2008 to early 2009, we can see the interest rate across the globe is dropping down due to global financial crisis. And also now we know that on December 2008, the official US interest rate is virtually zero. (While the interest rate like in Australia or UK are still heading down). But, the real problem is how do we know that it’s going to go up or go down next month ?

Nobody Can Predict the Market

This is a multi billion dollars questions that everybody wants the answers. Ask those stocktraders: if they knew that the price will go up, they will buy that stock heavily, if they know the price will go down, they will sell instead. Actually, this is happening in all sector of life: filling up petrol (wait for cheaper price tomorrow or today is good enough), buy that TV now or next Christmas sale, become a member now or maybe next year will be cheaper, etc.  But like it or not, we kind of know the answer: nobody can predict the market….

Now go back to the mortgage, if we don’t know whether next month the interest rate will go up or down , how do we decide whether to fixed the rate or keep it variable?

(Before we go on, I need to explain, especially to US readers, that most of the rest of the world hardly have a 30 years fixed term interest rate. Usually the fixed rate only applies for 5 or  10 years maximum, then it will revert back to the standard variable rate that will fluctuate based on the monetary policy from reserve bank)

Why Not Just Fixed It?

Just blindly fixing your interest rate is not really wise move. Some of the reasons:

• The fixed rate usually a little bit higher than the current variable rate. So choosing fixed interest rate instead of variable rate may cost you higher repayment immediately.
• Not only the current variable rate is cheaper than the fixed rate, but because the market of variable rate mortgage is bigger, usually you may have significant rate discount with many special offer.
• Usually with fixed rate, you cannot or only able to have very limited extra payment to reduce your principal
• If the reserve bank is in the middle of reducing interest rate month after month, then fixing your loan can be costly

.. then just do variable rate… No ?

Not quite as good as well, because:

• You may cannot afford to experience another interest rate hike.
• From time to time, lenders do promotion and offer a very good fixed rate discount which is too good to be missed
• Some time you don’t have other choice, i.e: the lender restricts you to have only fixed interest rate as condition (basically the lender is afraid that you cannot pay the interest should  there is any increase)

It’s all about Risk Management

Interest rate is one of risk factor when buying property – probably one of the major one. Hence, it’s very wise if we have some kind of plan to manage the risk should it arrives. When we apply for the home loan, we will ask how much will the repayment be every month whether we can afford it or not. But don’t stop here, you need to ask to yourself honestly can you still pay the repayment if the interest rate go up by 1% for example. If you cannot afford any significant increase, consider fixing your interest rate. Yes, perhaps you will pay a little bit higher repayment (usually fixed interest have higher rate), but this is the insurance that you take.

Remember your car insurance/auto insurance? You will need to pay upfront say $1000 just in case you have some accident this year. You will not know whether you will have accident or not (of course, you do not want) but you just pay the premium. If after one year there was no accident, will the insurance company give you back your $1000? Of course, no… you even pay another $1000 for another year….

The same thing with mortgage, if you cannot afford any significant interest rate increase, go fixed your rate and consider any extra repayment (although should not be that significant) as your insurance to mitigate this risk. You will earn your reward when the economy heats up and interest roof goes up to the roof you are the only one smiling…. Although remember that usually fixed interest rate only available for 5 years or 10 years (maximum) compare to 30 or 40 years variable rate.

Refinance/Remortgage Consideration: Cost Minimization

You have existing mortgage and consider to change your interest rate to fix or variable, one thing you need to consider is the cost associated with the change. The lender usually charge you some administration fee to change, not to mention if there is break fee/penalty fee. If you change lender, the cost and hassle will be more as they need to do valuation and sometimes you need to repay the mortgage insurance and other fee.  The cost can be significant.

Then, all come back to the actual number, for example: 0.25% difference on interest on $300,000 loan give you $750 a year difference. If the cost associated with the change is $2000, then you only see the benefit after more than 2 years… Who is the best person to do this cost benefit calculation in great detail: your mortgage broker. If you don’t have one, just go to several mortgage company… If you meet someone you like, just stay with him/her. Read: Why You Should Always Use Mortgage Broker For Your Homeloan for more detail.

What’s Best ?

The best alternative will depends on your situation and condition:

• If you’re in very tight situation where you really cannot afford any additional increase, then don’t waste your time:  choose the fixed rate today ! Your credit history (i.e: reputation) is much more valuable than some few hundreds dollar potential saving. You need to avoid a default (cannot afford a repayment) at any time.
• But if you still have a room for an increase and really want to maximize your savings, then probably you can wait until the next rate cut (with the possibility of increase instead of decreasing, of course) before fixing your interest rate. Just remember the risk.
• Everything in between I would recommend a split. Some with fixed interest, the other part with variable. Perhaps 50:50 or 40:60 or 30:70 according to your perception what’s is likely to happen. With this split arrange, you still enjoy a saving should there is interest rate cut, but not severely affected if there is a hike.

But the really important factor is that you need to crunch your number…. if the cost is too high, perhaps it will be more beneficial if you just stay where you are.

Hope this helps….

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• Taking a mortgage ? Do Not Change Your Lifestyle Dramatically
• Offset Account: A Must Have For Your Mortgage
• Be Careful With “Interest Only” Homeloan/ Mortgage: a Potential Problem You Should Know
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