Q. I have a home loan that I was paying interest only payments on.  After 5 years the loan has reverted to principal and interest payments.  The new interest rate is 6.61%.  I have been shopping around and have noticed fixed rates for 3 years are cheaper than this.  Should I fix the rate?  I always thought fixed rate loans were more expensive than variable.

A.  Banks set interest rates for mortgages based on the anticipated cost of funding to the bank over the period of the loan.  If the bank’s view is that rates will rise over time, then fixed rate loans will cost more than variable.  If variable rates are expected to fall then the reverse is true.  Picking when to fix home loan rates has developed into a “punting” exercise.  Sometimes you will get it right and often you will get it wrong.

Whilst not infallible or exhaustive, here are a few general principals for you to consider to reduce the chance of making mistakes when deciding whether to fix or not to fix.

If fixed rates are higher than variable, fix if a future rate rise will make the loan facility a stretch or will substantially disrupt your cashflow. This limits the maximum loan payments you will need to make for a period of time.

You can “virtually fix” rates by staying at variable rate but making contributions at whatever the higher fixed rate is. The additional capital payments will eat away at the balance without locking in the higher rate.

You are restricted on making additional lump sum payments on fixed rate loans so only fix the portion of a loan you don’t reasonably believe you can pay off over the duration of the fixed period.

Consider fixing rates if the fixed rate is lower than variable rates and you don’t see variable rates falling below the fixed rate on offer.  For example, if fixed rates were .75% lower than variable, it would need your bank to pass on more than .75% of RBA cuts for you to be worse off in fixing the loan. That would typically be 3 RBA meeting cycles.

If you are disciplined with your spending, consider using an Interest Only (IO) loan with an offset account attached to the loan.  Surplus savings can go into the offset account reducing the cost of interest on the loan.  The minimum monthly payment on the mortgage will be lower than that of a Principal and Interest loan if your circumstances change into the future.

Shop around for best deal in the market.  Take into consideration facility fees and break costs on loans to get a true indication of the costs of either switching loans or banks. Make sure the loan facility meets your current and future needs and likely circumstances.

Invariably what to do is best understood with 20/20 “hindsight”.

This Q & A was originally posted in The Australian