To fix - or not to fix?

In recent months there have been many questions that I’ve been asked continually. The ones that seem to be on everyone’s lips are about interest rates: what are they likely to do and what, as investors, should we be doing about them?

Interest rates have fallen considerably over the past eight months with the official cash rate now at .50% Many investors will now find their investment properties positively geared.

The questions most commonly asked is: should I fix my interest rate, and if so, when is the best time to do it? Unfortunately, none of us own a crystal ball, but we do have historical data and the ability to analyze this to forecast future trends.

Why you should consider fixed rates now?

Mortgage industry research over the past 27 years reveals that 83% of the time, the borrower with the variable rate loan was better off than the borrower with the fixed rate.

Having said that, fixing your interest rate does have numerous advantages, especially in today’s climate. The current low interest rates are likely to be of the “once-in-a-lifetime’ variety. Generally, the best time to fix is when the interest rate cycle is close to bottoming and when the prospect that cash rates will increase is in the near future.

In my opinion, borrowers should start considering their options now. With the government trying to boost the economy through various stimulus packages, we will get to a stage where it needs to ensure inflation is kept in check. To do this, the Band of England will probably increase the cash rate. If the stimulus package works as intended it will have an inflationary effect, which in turn will lead to an increase in cash rates.

If you’d like to know exactly how much you’ll be paying out from month-to-month without having to worry that your repayments may increase, fixed rates are for you. For investors, it is a promising situation to have the comfort of locking in your fixed rate and the certainty of a positive or neutrally geared property for up to five years.

Given that interest rates are at historic lows, rental yields are continuing to climb amid low vacancy rates. Because there is strong rental demand, now is the great time to be fixing your interest rates.

The downside to fixed-rate loans is the fact that you can be locked into a higher rate while variable rates are cut. To avoid putting all your eggs in one basket, the other options would be to have a bit of both by splitting the loan and having one portion fixed and one portion variable.

Fixed-rate strategies

For core properties that are earmarked for long-term holding, investors should look at fixing for a minimum of three years (or preferable five), assuming the property cash flow can be maintained at a neutral of better position. Ideally, investors should stagger the durations of their fixed rates to ensure they don’t all mature at the same time. Staggering the duration of fixed rates ensures the portfolio isn’t fully exposed to the current variable/fixed rate at expiration of the fixed rate agreement.

It is also important to keep in mind discount and specials on fixed rates when they are on offer. These discounts are a relatively safe way for lenders’ to attract your business because refinancing during a fixed term is rare.

If you do decide to go for a fixed loan, the next questions you face is how long do you want to fix it for? The most common fixed rate terms are one to five years, with some institutions also offering terms up to 10 and even 15 years. Right now, the shorter the fixed period, the lower the rate. This says to me that banks are aware that rates won’t stay low for too long.

Personally, if I could get a fixed rate loan for three to five years at the about 5% and I thought we were at the bottom of the cycle. I would be fixing my loan.

Historically, over the past 30 years interest rates have averaged around 6.5-8.5% pa. Again, for property investors an interest rate around 5% for up to five years could mean a neutral or positively geared property for the long term.

Factors influencing the fixed-rate market

Contrary to public opinion, fixed rates are not solely influenced by the Bank of England,they are also influenced by those who are investing in the fixed-rate wholesale markets.

Imagine if you had a store that is nothing but this new ‘must-have product’ called ‘three-year fixed’. As with most supply and demand economics, the store weighs up the price versus the demand. This is a very simplistic analogy, and there are many other factors that influence the price, but it’s an appropriate e example nonetheless. Fixed-rate loans are largely funded with money raised by lenders in global financial markets, plus a retail margins, thus a margin for risk. Variable-rate on the other hand are influenced the official cash rate set by the Bank of England, plus a retail margin added by the bank.

The Bank of England cash-rate target has historically been the benchmark for sitting wholesale mortgage rates in UK. Therefore, consumer mortgage rates are generally priced at a premium over the cash rate, reflecting the borrowing rate between the Bank of England and lenders plus a risk margin for lending fund to consumers.

Recently, we have seen lenders move their variable rates outside the official BoE movements, doing do when the cost of providing funding increases. Obviously the reverse also holds true - which applies to the fixed rates as well.

Exit fees

There are many reasons investors are nervous about fixed rates and one of these is the exit fees/break cost. So how sure are these calculated?

An exit fee is a one that’s charged by lenders when you repay your loan before the expiry date. For most lenders, this fee is applicable if the loan is repaid in full either in the first, second, third or fourth year.

It can either be a flat fee charged or a percentage of original loan amount – depending on the lender.

Fixed-rate break costs

The break cost is a fee charged by lenders when you either make extra repayments on a fixed-rate loan, or repay the loan entirely before the expiry date. Most lenders allow you to repay a small amount of your fixed-rate loan, but exceeding these incures break-cost fees. The number of extra repayments that a lender allows you to repay will depend on which lender you are using. Different lenders use different names for break costs.

How lenders calculate break costs

Lenders calculate break costs by working out the difference between the wholesale rates from the time you applied for the loan to when you would be repaying it, multiplying it by the loan amount and the remaining term of the loan. There is no standard formula. Each lender should detail a formula for calculation in their fixed-rate loan contract. For example:


Break Cost=
Loan amount
X
Remaining fixed interest rate term
X
Change in wholesale rate


If interest rates have increase since the time you fixed your loan, you may not be charged a break cost fee for breaking your fixed interest rate contract because the lender would actually make money out of you breaking your contract. Despite this, however, some lenders may still charge you a fee – clarify this with your specific lender.

Generally speaking, the biggest problem with fixed-rate products is that they are not flexible. When we talk about fixed term, the usually time period may range from three years up to 10, or even 15, during which, someone’s financial position can change dramatically.

And ideal fixed rate product would be one that has the best interest rate and lets you put in or take out as much as you want, while allowing for revaluation, tops-ups and minimal break fees if you refinance. Unfortunately, like most things in life, you don’t always get what you wish for. Go for the product that


Break cost calculation example

Mr. John Smith has $500,000 loan with ‘Bank limited’, which he locked in to a five-year fixed interest rate of 7% pa. After that first two years, John requests to break his fixed-rate contract.

The wholesale rate has dropped by 2% since the time John entered into his fixed rate contract.

The break cost to john would be as follows:

Break cost=
Loan amount
X
Remaining fixed interest rate
Term x
Change in wholesale rate

Break cost=£500,000
X 3 years x 2%
Break cost= £30,000

Meets your immediate requirements (for most of us, its good interest rate for a defined term) but don’t forget to keep in mind the things that are important today may be worthless tomorrow.

Personal situations play a major role in finance strategies, and the same thinking applies to optimum length of fixing. Form a financial perspective, the main factors to consider when deciding on the optimum term length are the best interest rate and predicted movement of the variable rate over the fixed term.

In a nutshell, the optimum term largely depends on your individual situation and need for flexibility in a certain time period.

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