No Huge Savings in Switching to a Variable Rate Home Loan

Post by Sharat on November 10, 2008 · Under Featured Articles, Hints and Tips, Self Help, home loans, mortgages · Comment

One could be forgiven for looking at declining interest rates, and feeling a little buyers remorse if you recently took out an Australian mortgage and opted to pay a fixed interest rate. Switching from a fixed to variable interest rate could save mortgage holders several thousand dollars a year. But if you have recently taken out a home loan and chose to pay a fixed rate, then exiting the agreement is simply cost prohibitive.

A loan of $300,000 for a 3 year period that had a fixed rate of interest of 8 per cent a year would cost $2000 more than the same loan on a floating or variable rate. Saving that kind of cash from converting your mortgage from a fixed to a floating rate loan however could only be made if the loan was at or near the end of its term. If the loan has most of its life to run, then breaking the agreement and switching would cost around $10,000 and any savings made in switching would be eaten up in punitive fees.

Different funding sources underlie the fee for breaking a loan. Standard variable loans are largely funded by deposits from savers; fixed rate loans use a much higher share of expensive short term wholesale funding, the cost of which is locked in when the loan is taken out. Timing is therefore critical in deciding whether to convert your fixed rate mortgage into a floating or variable rate loan.

Fixed interest rate loans have their advantages. If you are on a strict budget, and you want to lock in a rate, that you can work and plan around, then obviously the fixed interest rate is helpful. It does also provide protection from when interest rates rise. Though it is hard to see that happening for at least the next year anyway.

The most attractive variable rate, before the Reserve Bank slashed the target cash rate by 75basis points last Tuesday, was pegged at about 7.5 per cent. This compared to a one-year fixed-rate loan as low as 6.7 per cent, rising to 6.8 per cent for two years and 7.2 per cent for three years.

The big banks aggressively cut fixed-rate products in the lead-up to last Tuesday’s announcement, because such loans are priced with reference to market expectations of rate movements over the next three years or so. As recently year ago, as rates rose, about 30 per cent of new loans were fixed, but now, as rates fall, almost all new loans were variable a CBA spokesperson said.

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