In recent months there are many questions that I get asked continually, however the ones that seem to be on everyone’s lips are centred around interest rates, what are they are likely to do and what, as investors should be we be doing about them.

Interest rates have fallen considerably over the past 6 months with the official cash rate now at 3.25%. Many investors will now find their investment properties neutrally geared if not positively geared. This situation is in stark contrast to the previous 10 years where the majority of investment properties were negatively geared.

The question most commonly asked is - should I fix my interest rate and if so when is the best time to do so?  Unfortunately none of us own a crystal ball, however what we do have is historical data and the ability to analyse them to forecast future trends. 

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

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

In my opinion, borrowers should start considering their options now!  With the Government trying to stimulate the economy through various stimulus packages, we will get to a stage where they will need to ensure inflation is kept in check. To do this the RBA generally increases the cash rate.  Depending on how well the stimulus packages work, will greatly influence when we see inflation increase and cash rates increase.

If you like to know exactly how much you are paying out from month to month without having the worry that your repayments may increase, then fixed rates are for you.  For investors, the comfort of locking your fixed rate in and having the certainty of having a positive or neutrally geared property for up to 5 years is a promising situation.

Given interest rates are at historic lows and rental yields continue to climb amidst low vacancy rates and strong rental demand, now is a great time to be fixing your interest rates.

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

For core properties that are earmarked for long-term hold, investors should look at fixing for a minimum of 3 years, preferably 5 years, as long as the property cashflow can be maintained at a neutral or better position. Ideally investors should stagger the duration 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 fixed rate agreement.

It is also important to keep in mind discounts 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 rate loan, the next question you face is how long do you wish to fix your loan for?  The most common fixed rate terms are 1-5 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 rates won’t stay low for too long. 

Personally if I could get a fixed rate loan for 3-5 years circa 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 9-10% p.a.  Again, for property investors an interest rate around 5% for up to 5 years could mean a neutral or positively geared property for the long term.

So what influences the Fixed Rate market?

Well contrary to public opinion fixed rates are not solely influenced by the Reserve Bank. Rather, they are also influenced by those who invest in the fixed rate wholesale markets. Imagine if you will a store that sells nothing but this new `must have product` called 3 year Fixed. As with most supply and demand economics the store weighs up the price verses the demand. Sure this is a very simplistic analogy and there are many other factors that influence the price but a good example none the less.

Fixed rate loans are largely funded by money raised by lenders in global financial markets, plus a retail margin, plus a margin for risk.  Variable rate loans on the other hand are influenced by the official cash rate set by the Reserve Bank of Australia (RBA) plus a retail margin added by the bank.

The Reserve Bank cash rate target has historically been the benchmark for setting wholesale mortgage rates in Australia. Therefore, consumer mortgage rates are generally priced as a premium over the cash rate, reflecting the borrowing rate between the RBA and Lenders plus a risk margin for lending funds to consumers. 

Recently, we have seen lenders move their variable rates outside the official Reserve Bank movements, and will do so when the cost of providing funding increases. Obviously the reverse also holds true and can apply to Fixed Rates as well.

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

An Exit Fee is a fee which is charged by lenders when you repay your loan prior to the loan expiry date. For most lenders this fee will be applicable if the Loan is repaid in full either in the first, second, third or fourth year.

The Fee can either be a flat fee charged, or a percentage of the original loan amount, depending on the lender.

Fixed Interest Rate Break Costs

Break costs is a fee charged by lenders when you either make extra repayments on a fixed rate loan, or repay a fixed rate loan entirely prior to the fixed rate loan expiry date.

Whilst most lenders will allow you repay a small amount of your fixed rate loan, if you exceed this amount, a fee will apply. The amount of extra repayments that a lender will allow you to repay will depend on which lender you are using. Given that lenders often change their policies from time to time, you should also check with the lender how much extra repayments you are entitled to make without a break cost being applicable.

Different lenders use different names for break costs, some names used by some of the major lenders are :-

• Westpac Banking Corporation    “Break Costs”
• Australia & New Zealand Bank    “Early Repayment Fee”
• National Australia Bank              “Prepayment Fees and Economic Costs”
• Commonwealth Bank                 “Early Repayment Adjustment”
• St.George Bank Limited             “Break Costs”  

Lenders calculate break costs by working out the difference between the wholesale rates, between the time when you applied for the loan and the time when you repay the loan, and multiplying it by the loan amount and the remaining term of the loan.

There is no “one” standard formula that is used by all lenders, as each lender has their own specific method of working out their break costs. Each lender should detail in their fixed rate loan contract their formula for calculation. An example formula is :-

Break Cost = Loan Amount x Remaining Fixed Interest Rate Term x Change in Wholesale Rate

If interest rates have increased since the time that 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 from you breaking your contract. Despite this however, some lenders may still charge you a fee, as such you need to clarify this with your specific lender.

An example of a break cost calculation is as follows :-

Mr John Smith has a $500,000 loan with “Bank Limited” which he locked into a 5 Year Fixed Interest Rate of 7% p.a..  After the first 2 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

It is important to note that the above calculation is an example only, and you should also refer to your fixed rate loan contract and/or your lender for an accurate break cost calculation.

Generally speaking, the biggest problem with fixed rate products is they are not flexible. When we talk about fixed term, the usual time period may range from 3 year up to 10 or even 15 years and that is a long time for someone’s financial position to change dramatically.

An ideal fixed rate product would be one that has best interest rate, the interest rate goes down if the index rate goes down but stays there if the interest rates moves the other way, allows you to put in or take out as much as you want, allows for re-valuation and top-ups and minimal break fees if you refinance. Now some dreams do come true but unfortunately, like most things in life, you don’t always get what you wish for.

Go for the product that meets your immediate requirements (for most of us, it’s the good interest rate for defined term) but amidst that don’t forget to keep in mind the things that are important today may be worthless tomorrow.

Personal situations play a major role in deciding a finance strategy and the same ideology applies to the optimum length of fixing. Taken those variables out, from a complete financial perspective, the factors that decide the optimum length of time are – term with best interest rate - predicted movement of the variable rate over the fixed term - variable rate at the end of the fixed term and the fixed rate at the end of the fixed term.

In a nutshell, the optimum term largely depends on individual situation and need for flexibility in certain time period. From financial point of view, 4-5 year terms are providing better yield than others, but may change as the fixed rate market is predicted to move with the variable in market in the forthcoming time.

I would like to thank my team of Mortgage Strategists at Investors Direct for their expertise and contribution to this article.