Fixed v Variable - What will work for you?

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Market predictions continue to fluctuate and speculation about rate increases leave most of us wondering whether to opt for a fixed rate or hedge our bets on a variable rate.  Based on a prediction that rates will be close to 8% within 18 months, I thought it timely to compare the two side by side.

For the most part rates are set to increase in the short term. The RBA moved earlier this month increasing the cash rate by 0.25% with the market predicting another 0.50% increase when the RBA meet on Melbourne Cup day. What do I do I hear you say?

The bottom line is there are no standard answers and everyone’s circumstances with dictate how you will respond to the ever changing market. As an investor you may be looking to take a fixed position to ensure you understand your cashflow from one month to the next, an owner occupier may be looking at repayment affordability and deciding on the best balance between fixed and variable.  What ever your situation, the best you can do for you and your family is to make informed decisions, this often means having someone else look at the numbers for you.

To illustrate the impact of your decisions I have created loan scenarios for two families each having a $250,000 mortgage. Family A decide to weather the rate rise predictions and leave the entire mortgage at the variable rate, whilst family B decide to fix the entire loan for 3 years.  The scenario looks at the next 36 months or 3 years and we will examine and the pro’s and con’s of their respective decisions.

Similar to many economists I have looked into my crystal ball and made some predictions as to when and by how much rates will rise, I settled on seven consecutive increases over the next two years.  No I’m not saying this will happen, I’m simply following the market prediction to give you an idea on how it could look.  I have included the October 0.25% increase and taken an average of six lenders for the Standard Variable Rate.  The fixed rate is also the average of six lenders. 

Well done for noticing the huge starting gap between fixed and variable.

As you can see the graph clearly demonstrates the steady increase to repayments on the variable loan in response to our predicted rates increases leaving our fixed rate family secure knowing their repayments are not being affected.  The true measure comes at the end of the three year sample period when we reveal that family A made $60,869 in repayments whilst family B made $63,114 in repayments.

Family A saved a little over $2,200 by choosing to stay with an all variable strategy.  A pleasing result you might say, however savings aside let us consider the potential impacts of each strategy.

Fixed Rate Option:

Pro’s – Security of knowing your repayments, no redraw.

Con’s - No redraw, limited additional repayments, no offset account, switch fees and a potentially higher rate for an extended period.

Variable Rate Option:

Pro’s – Additional repayments are not capped like fixed loans, Offest account and redraw available.

Con’s – Uncertainty of repayments in response to rate rises, possible rate rise above the current fixed rates.

In a nutshell, you need to consider your financial situation, your family and your cashflow.  It's worth noting, this example is based on a standard variable rate, consider the difference if family A had the opportunity to restructure to a better deal with smarter options.