Fixed-rate loans give borrowers greater certainty. They know in advance exactly what their loan repayments will be for a set period of time. In Australia, the maximum fixed-rate term offered is 10 years, however, most fixed-rate borrowers fix their rate for terms of up to five years.
This certainty comes with the price tag of loss of flexibility. Prior to the maturity of the fixed rate, borrowers are restricted to repaying limited set additional amounts off the loan without incurring break costs and/or penalty interest. This amount varies from lender to lender but generally ranges from $5,000 to $10,000 per annum. If a borrower repays principal amounts greater than this or pays the loan out in full, they would be charged the break costs incurred by the lender.
Break costs are principally the potential loss the lender will suffer as a result of the borrower reducing the loan amount under the fixed-rate contract by more than what is allowed. To calculate the break costs the lender essentially looks at their original cost of funds for the loan compared to the return they can receive on the loan funds for the balance of the fixed-rate period. If the loan is repaid early this loss is then brought back to a present-day value.
If interest rates increase, little or no break costs are payable. If interest rates decrease, the break costs will increase and the more interest rates decrease the greater the break costs increase, as the greater the potential losses to the lender of a borrower “breaking” the loan contract set at a higher interest rate. It is possible that the loss the bank incurs on an individual loan can actually give them a profit. This is because the bank can invest the money at a higher rate if interest rates have increased by enough. However, lenders typically do not pass the profit onto the borrower. Some lenders charge the break cost or three months’ interest, whichever is the greater.
When assessing whether to fix the interest on borrowings, an investor is generally motivated by one or two reasons. Firstly, as a borrower, they believe the fixed interest rate for the term of the loan will be less than the variable rate. Secondly, they simply want the peace of mind of knowing exactly what their loan repayments are going to be for the period of the fixed rate even though they may think the variable rate may be lower.
As we have mentioned, fixing the rate will probably mean the loss of the flexibility of being able to pay large additional principal payments off the loan or being able to pay the loan out in full without incurring break costs. However, property investors gearing their investment are generally less concerned about paying off principal because of the tax deductibility of the interest and a preference to use their cash flow to build equity through growth rather than debt reduction.
Deciding whether to fix none, part, or all of an investor’s borrowings will also depend on where in the interest rate cycle the economy exists at the time. If too high a premium has to be paid by way of a higher interest for the fixed rate compared to the variable rate, then any advantage of reducing exposure to increasing interest rates is quickly dissipated.
Because interest rates are highly unpredictable, you should never advise a client to either fix their rate or choose a variable rate. Likewise, you should never try to predict the direction of future interest rates. The best strategy is to point out the advantages and disadvantages of both and leave the decision to the client.
You should base your financial calculations on an interest rate higher than current rates and recommend clients maintain some form of cash reserve to assist with payment of interest for the period of time interest rates are greater than what has been planned. The size of the buffer would depend on the risk profile of the investor, the size of their borrowings and their overall level of debt in relation to their assets.
Strategically, deciding to fix the interest rate, or not, on all or part of their borrowings will depend on each investor’s individual circumstances.
|List the two major differences between a fixed-rate loan and a variable-rate loan.