To Fix or not to Fix: To insure or to bet?

How should you choose between a fixed and a variable rate? One way to look at the choice is to think of its as a gamble. If rates go up while you've fixed, your bank's margins get squeezed and you win the bet. But if you do look at it as a bet remember you're likely to lose!

Why? Well there are a variety of reasons.

• Long term interest rates tend to be higher than short term interest rates. When you think about it, this is a bit surprising. Because the longer term is nothing but the sum of the short terms that make it up. It happens because borrowers are prepared to pay a premium to reduce their exposure to the risk of rising interest rates. So lending long is a recipe for paying interest at a higher level - though of course if you get your timing good enough, you can fix at the bottom of the market and sit pretty while interest rates rise on everyone else!

• Margins on fixed rate loans tend to be greater.Ever noticed that while you can get standard and 'discount' variable rates, there aren't standard and 'discount' fixed rates. In fact fixed rates tend to have greater margins than discount variable loans, yet the flexibility of a fixed rate loan is even less than most discount variable loans.

• If you find you need to exit a fixed rate loan you pay penalties. Lets say the rate goes down. In that case, you've lost your bet because you would have been better off on variable rates. Instead the lender has got you committed to borrowing at a higher rate. If you are then allowed to get out of your loan you pay penalties. That's fair enough, because otherwise the loan would be fixed for the borrower but not the lender. On the other hand lenders have the right to charge borrowers, and frequently do, when the borrower has 'won the' bet (interest rates have gone up above the fixed rate), but must for whatever reason exit the loan.

Between September 1990 and April 2001, the average standard variable rate with Australian financial institutions was 9.24%pa. This compares favourably with the average fixed interest rate, which stood at 9.38%pa. In fact, over the period from September 1990 to April 1998, borrowers with variable rate loans almost always did better than their fixed rate counterparts.

This is illustrated in the graph below. First, we calculate the average rate a variable rate borrower would have had to pay over a three-year period. We then compare that to what a fixed rate borrower pays over the same three-year period and use the graph to show the difference. The graph is almost invariably below the zero mark, which indicates that over the period, the variable rate borrower paid less than the fixed rate borrower.

Between 1990 and 1998, 82% of those who chose to fix lost their 'bet' that rates would rise enough in the future to justify them taking out insurance and fixing.

An even more dramatic statistic shows that, from 1996 to 2000,100% of those who chose to take advantage of discounted variable rates ended up better off than their ‘fixing’ counterparts. The average discounted variable rate was 7.53%pa. The average fixed rate was 8.00%pa over the same period of time.

So if you're into betting on interest rates, you might be better off taking out a variable loan, and going and betting the amount it saves you over and above a fixed loan, down at the Casino. You'll have about the same chances of winning.

Does this mean that fixing is a mug's game. Not at all. Its insurance. When you insure your house your 'betting' the insurance company that your house will burn down. You lose your bet - the premium - if it doesn't burn down. But you're doing it to lower your risk.

Fixing the rate of your home loan is best thought of as an insurance policy. We don't really expect to make money, or ‘win’, when we take out insurance. We do it to prevent possible losses which would be too great for us to bear comfortably. Similarly, we are unlikely to ‘win’ by fixing our home loan interest rate with a financial institution. It happens, but not often. But we do insure ourselves against a disaster should variable rates rise substantially. But don’t worry, you won’t have to deal with any insurance companies! Just lenders.

You need to work out how much you need insurance when taking out a home loan?

We can never predict the future with complete certainty, and you must always be prepared for the unexpected. As a general rule, we suggest you consider fixing if a 2% pa rise in variable rates would be uncomfortable, and 3%pa would lead to serious difficulty. If you are in such a position, then the peace of mind will be worth the extra money you’ll probably end up dishing out.

Cheers

Nicholas Gruen
AKA Nicholas Gruen
June 2002

Please note: The observations made here are general and indicative.Nicholas Gruen is not a qualified investment adviser. Further his comments are general and do not take into account your specific circumstances. Nor are they warranted as free from error in any respect whatsoever. You should not rely on any aspect of them without taking independent financial advice relating to your own specific circumstances. We suggest you obtain advice on a fee for service basis rather than from someone who earns either up-front or trailing commissions from investments they recommend. We would be happy to let you know of service providers who provide advice on this basis.

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