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In a fix

Peter Switzer
26 June 2009

For those in a quandary over whether they should be fixing their home loan interest rates or gambling on the more volatile variable rate of interest, this is your chance to see what’s going on in my head about this thorny, hip-pocket dilemma.

A reader called Jessica recently sent me an interesting question, which I am sure many other Aussies are scratching their heads about. Given the questions she raised, and to do the issues justice, I have decided to dedicate a full story to the answer rather than the usual shorter Q&A treatment I give to reader enquiries.

First homebuyer query

Here’s the question: “My partner and I are applying for a home loan for our first home, which we plan to live in for around five years. People around us have mentioned some advantages and disadvantages of both interest only and principal and interest loans, but the more we hear the more we are confused. How does each work and what are the pros and cons? And does the fact that we will only be in this house for a few years make any difference?”

Time makes a difference

Let’s take the time period first. As you plan to live there for only five years, it makes sense to consider a fixed rate option. If you were there for a long time, there could be a case for going for a variable, as it’s often argued that it’s swings and roundabouts.

On the other hand, I know many experts who believe that fixers usually get it wrong. However, I would say when interest rates are rising, the panic merchants often fix their rates at the point of maximum fear and that’s often close to the top of the interest rate cycle.

Low interest rates

We are now closer to the bottom of the interest rate cycle and it makes more sense to think about fixing. Also, with big government spending now, many economists think we will have inflation problems in two-years time or even before.

That means rates could fall 0.25-0.5% before starting to rise again, possibly in 2010. But I wouldn’t expect a massive rise for quite awhile, say in three to four years time.

When I checked, the best variable interest rate was at HomeStar at 4.82%. Banks are charging around 5.15%. Here is a word of warning — always look for the comparison rate of interest as this adds in all of the other charges. Don’t get fooled by the advertised rate.

Compare and contrast

On interest rate comparison websites, it was easy to find three-year fixed rates and they are around 5.49% to 5.79% at the banks, but Better Option home loans have a 5.19% product.

I found it’s really hard to find current five-year fixed rates, which might be the best bet as interest rates will rise over five years for sure, but the rates I saw were around 6.64%. These were advertised rates, so the comparison rate could be close to 7%.

So for two years you might be paying 7% while those on variable rates could be paying 5.19% or a bit higher or lower, depending on what happens over the next year.

If we go into a deeper recession than expected, then variable rates will fall.

I don’t think we will slump badly but I could be wrong. Now you are seeing the gamble.

By the way if you lock in for three years, when your loan matures you might have to look for a new loan in a much higher interest rate environment.

Loans explained

On how each works, the principal and interest loan sees you pay off interest and a little bit of principal with repayments but it’s mainly interest in the early years and that’s why interest only might suit you. Also, interest only repayments should be smaller, so it can help cash flow and may mean you can buy a more expensive house.

With interest only loans, you simply pay interest. These loans are often used by landlords as the interest is tax deductible, but it would not be deductible for you unless you rented the place out.

Lock it in?

Locking in the rate can give you peace of mind that your repayments won’t go through the roof.

However, it can be annoying if rates fall, though I can’t see many more falls.

If you were going to live in the place for three years, the fixed rate option might seem pretty sensible but as you plan for five years, the last two years could be tricky.

Smarties might say in the fourth year you could go for a home loan that has a one-year low introductory rate but switches to a higher rate in year two. That way you would only have one expensive year of interest rates, but as you can see, it’s a very big gamble.

Bit of this and a bit of that

For people planning to stay in their house, a cocktail of part fixed and part-variable can mean you pay off the variable part as fast as you can and the part fixed portion can soften interest rate rises.

Pay more off when you can

Paying off your home loan with bigger repayments and throwing your tax refund cheque or any other windfall at the principal can save heaps of interest and time off your home loan.

Good luck with your decision — it’s a tough one! Hope this helps.

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