The following is an extract from award-winning consumer finance help book, Mortgage Free Debt Free. Click to learn more about the book.

Fix your mindset or your mortgage

In the case of rate type, you have a simple decision. Either you fix your interest rate, or you do not. Understanding and considering each alternative carefully is the only way you can make the right choice. Like all things mortgage related, the rate type needs to be your decision because you bear the impact.

If you don’t fix, your interest rate will be variable. Your lender can change it either up or down, by as much as they like, any day of the week. Therein lays the risk of taking a variable rate mortgage. The sixty four dollar questions are, will they, if so, by how much, when and for how long?

The answer of course is, buggered if I know. As we talked about in “The Unfun Rollercoaster”, since October 2007, the factors influencing interest rates have changed. Up until that time, the interest rate on a variable rate mortgage moved largely in line with the ‘state of the economy’.

When the economy was booming, employment would go up and wages would go up. So too would the interest rate on your variable rate mortgage, because that is when the RBA increased its Cash Rate. This made interest rate changes somewhat predictable and meant the historical risk and impact of a variable rate mortgage was relatively low. When interest rates rose, you were probably doing okay yourself and could comfortably cope with a bigger dent in your wallet.
However in October 2007, BankWest, now owned by the Commonwealth Bank, broke ranks and started moving their interest rates up, independent of the RBA. What started out as an unnoticed blip quickly became common practice for many lenders. ANZ was the first of the big four to try it, the Commonwealth Bank following not long after.

Each of the majors did it a second time and discovered that, although they got a bit of bad press, borrowers continued to flock to them and they still made gargantuan profits. So they did it again. And again. But this isn’t about bashing the banks. Most of the building societies, credit unions and non bank lenders did it too. Since that time, a bunch of other things have happened and lenders have become empowered and emboldened. They drive variable interest rates up whenever they feel like it and by as much as they want. They also refuse to pass on RBA rate cuts that in the past would have reduced your interest rate, winding back your financial pressure, or accelerating the rate you repay your loan. So now, on top of the general economic triggers affecting interest rates, you must also deal with the practice of lenders striving to out profit each other by moving interest rates independent of the RBA. This increases the risk for anyone on a variable rate mortgage today, compared to someone on variable rate back when the banks toed the RBA line.

Nowadays, when interest rates rise, your ability to cope is less likely to keep pace and you may not be doing so okay yourself. Just as importantly, when the economy slows and mortgage rates should help you along by falling, your interest rate may just as easily stay where it is, fall by two tenths of bugger all, or perhaps worse yet, increase. As has been proven time and time again, lenders will always act to protect themselves, even if it is at your expense. We need to think about the impact of this increased risk more carefully today than ever before. It is now far more likely to happen and when it does, you want to make sure you are prepared for it. What happens to your comfort zone if the lenders decide to increase rates another one or two percent above RBA recommendations? If you followed the steps in “How much should you borrow?” the buffer you created on current interest rates means the ups and downs of the interest rate cycle should be quite manageable. Your comfort zone takes up the slack that your buffer can’t during the top end of the rate cycle; then your buffer kicks the living daylights out of your debt at the bottom of the cycle, so you’ve got it made in the shade.

On the other hand if you’ve got one or more feet planted in the “Screw it let’s do it” camp by budgeting repayments closer to current rates, you have probably left yourself little or no buffer for those ups and downs. Your journey will likely be a little longer, and quite a bit bumpier as you will suffer a greater impact each time the risk of increased interest rates becomes real. To some extent or another, it always does so if we can’t fix your mindset, you might want to fix your loan.

A fixed rate is a loan with an interest rate that doesn’t change for a certain period of time. This means your minimum repayments won’t change either and this could help you stay in control. If you’re not interested in fixing, it is still worth learning about these loans because this little bit of knowledge certainly can’t hurt, whereas not having it certainly can. However whether you should actually take a fixed rate is an entirely different story. In Australia the idea of a fixed rate mortgage is a little bit bullshit because in reality, there is no such thing. They probably should be called something like “Introductory Fixed Rate Variable Rate Mortgages”.

While it’s pretty obvious that I’m not the best person for product names, the point is that you cannot get a fixed rate that lasts for the full term of your loan. In fact the vast majority don’t go past 5 years, which, unless you win Powerball, is a long way short of the typical loan term. So while you get some reprieve from the Repayment Rollercoaster with a fixed rate, it’s relatively short lived.

In the past, with very few exceptions, taking a fixed rate has almost always cost borrowers more in interest and fees than taking the same loan on a variable rate. Which makes some people think “Screw it, why do it?” The answer is simple. Peace of mind. If you are thinking about fixing your interest rate then, “saving interest” is probably way down your list of priorities, somewhere below “sleeping well” and “keeping the farm”. A fixed rate mortgage is an insurance policy against financial pressure brought on by interest rate hikes. And for any kind of insurance you should always expect to pay a premium.

Fixed rate loans definitely do not suit everybody.
If you repay a fixed loan before the end of the fixed term, in full or
for most lenders in part, you may have to pay Early Repayment
Penalties.

Penalties can also be triggered if you switch to a different loan type
during the fixed rate period even if you stay with the same lender.

Early Repayment Penalties can be MASSIVE and often vary from day to day. Although true for any mortgage, before taking a fixed rate term, make absolutely sure you fully understand the Early Repayment Penalties that may apply to you.

Most lenders can give you an estimate of an Early Repayment Penalty, but the actual cost will be determined on the day that the early repayment event occurs.

In the year between August 2007 and July 2008, interest rates on competitive variable rate mortgages rose by around 1.30% p.a. Many experts would have considered that increase unlikely. No matter what the risk actually was before it happened, it still happened. During this period, some borrowers raced to fix, others with more sensible repayment budgets rode it out, some stressed and survived and some people lost their homes. Each borrower experienced that rate hike differently and each suffered a different impact.

Some borrowers may also have taken fixed rates a few years earlier for temporary relief from the Repayment Rollercoaster. For many, those fixed rates were about to expire in the middle of a peak interest rate spike. No doubt those people, who paid a premium to be stress free for a time, were now feeling more than a little stressed.

However if borrowers were fixed during this entire period of higher interest rates, they would have been able to sit back laughing knowing both their lifestyle and property were safe. Of course smart borrowers who correctly set their repayment budget in the first place also managed the interest rate spike easily as their comfort zone and advance payments were taking up the slack. The flipside to this is that in the following twelve months, interest rates plummeted at record speed to historic lows. Loans with rates close to 9% in August were now in the 5% range. Of course fixed rate borrowers had the certainty of being locked in at much higher interest rates and paying well over the odds. In the meantime, the smart borrowers kicked the living daylights out of their variable rate mortgages at record pace and wondered what all the fuss was about.

Taking a variable rate mortgage is a gamble.
Taking a fixed rate mortgage is gambling too.
You’re just backing the other team.

By all means look into taking a fixed rate with the knowledge that for a period you’ll have certainty over repayment size, the lender you are stuck with and the interest you will pay. However you should also remember that certainty can still be stressful as well as costly.
Oh, and one more thing. If you are unsure whether to fix your rate or stay variable, merchants are likely to suggest a part-fixed and part-variable loan. The reassuring advice is ‘you get the best of both worlds’. While it might sound tempting, it’s the merchant that gets the best of both worlds, not you.

The fixed part, usually at a higher rate, anchors your whole loan with them no matter how well they look after you. It strips away your flexibility to vote with your feet. At the same time, if rates increase, your repayments also increase on the variable portion, stripping away repayment certainty, which is the only advantage of
a fixed rate loan.

If you are still stuck in a land of indecision, consider staying variable, increasing your payments to slightly more than they would be if you took out a fixed rate loan today. Of course that might be a lot harder to do if you took the “Screw it let’s do it” approach. No matter what, now is not the time to make up your mind.
Wait until you finish reading this book.

If you fix:
Make sure the rate is either locked or capped at the time of your
application.
Locked means your rate is guaranteed not to increase prior to settlement. Capped means it won’t increase, but if Fixed Rates fall, you will get the lower rate. There are usually time limits that apply to the length of the guarantee which will vary from lender to lender. If you fail to ‘lock’ or ‘cap’ your rate, fixed rates could increase before your loan settles and you will be stuck for years on a rate that could be much higher than the interest rate you applied for.

*The empirical data used in charts and statistics is derived from the Reserve Bank of Australia’s (‘RBA‘) Indicator Lending Rates – F5 report and was last updated 2 January 2015.