Why a gulf has formed between fixed and variable interest rates

A wide gap has formed between interest rates for fixed and variable home loans, but borrowers may have a limited window of opportunity to take advantage of it.

Analysis of average rates offered by lenders shows the difference between fixed and variable interest rates has grown significantly in recent weeks as COVID-19 support measures kick in.

Average fixed interest rates have been lower than variable rates by about 30 basis points for the past five years. That difference stretched to 57 basis points over the second half of last year before suddenly growing to 84 basis points throughout March and April, according to analysis by Canstar.

Lenders, spurred on by measures to dramatically decrease banks’ funding costs to shore up the economy against the effects of the coronavirus pandemic, are offering record low fixed rates, the cheapest nearing 2 per cent.

“Wholesale funding costs for banks have reduced, particularly for medium term money, allowing the banks to pass on lower fixed rates to borrowers,” said Canstar group executive of financial services Steve Mickenbecker. 

The average three-year fixed rate is 2.64 per cent, and the average variable rate is 3.48 per cent for owner-occupiers taking out principal-and-interest loans. 

A borrower with a $400,000 loan would pay $175 less per month, or $2100 per year, if they opted for a fixed rate loan over variable.

“It is a very wide gap,” said AMP Capital chief economist Shane Oliver. “Bank customers, if they’re somewhat clever about this sort of thing, would be wise to have a conversation with their bank.

“It’s quite possible they might be able to get a deal on their variable rate.”

The banks, not borrowers, have recently benefited most from fixed loans. So is it a good idea to fix, and how long will the deal last?

Why fixed rates are lower than variable rates

A difference between fixed and variable rates often reflects lenders’ expectations that cash rate cuts are on the horizon.

“Typically, it means rates have got further to fall,” said Domain economist Trent Wiltshire. 

Deals become more attractive as the likelihood of a cash rate cut increases, a scenario which played out late last year.

Recently, fixed loans have turned out to be a better deal for banks than borrowers.  

Customers who fix are locked into their rate for the fixed period, with three years being the most popular term.

When variable rates fall, fixed customers are stuck paying their original rate, and face hefty break costs to refinance into a cheaper loan.

The average fixed rate offered fell 130 basis points in the past 12 months, according to Canstar. Over the same period, the Reserve Bank cut the cash rate five times by a total of 125 basis points, including a second emergency cut in March to support the economy through the coronavirus crisis.

Borrowers who fixed in the past year might now feel a little shortchanged. The lowest fixed rate just one year ago was 3.49 per cent for a three-year fixed loan, compared to 2.09 per cent offered today.

For a $400,000 loan, that’s a difference in repayments of $287 per month, or $3444 per year.

Why have fixed rates plummeted recently?

Although low fixed rates often precede cash rate falls, further cuts seem unlikely. 

At the RBA’s emergency March meeting, board members agreed that “the cash rate was now at its effective lower bound” and there was “no appetite for negative interest rates in Australia”.

So what’s behind the latest falls in fixed rate loans?

The RBA’s latest statement on monetary policy stated recent reductions in fixed rates could be explained by the cheap credit provided to banks through the Term Funding Facility, one of the economic support measures announced by the RBA in March.

The $90 billion scheme is designed to lower funding costs for the entire banking system and reduce interest rates for borrowers. It involves the RBA providing a three-year funding facility to banks at a fixed rate of 0.25 per cent.

Minutes describe this as “substantially below lenders’ current funding costs”.

Banks are allowed to obtain funding of up to 3 per cent of their outstanding credit until the end of September.

“A bank has certainty of funding at 0.25 per cent for three years,” said Mr Oliver. “They obviously will take advantage of that.”

So what does that mean for borrowers?

With interest rates at record lows and banks given dirt cheap funding, it’s no surprise that rates for three-year fixed rate loans are a hair above 2 per cent.

But given the RBA’s September end date, it’s possible the deals won’t last.

“You would be best to try and lock it in now,” Mr Oliver said. “There is a chance it could end around September, but that all depends on which way the economy goes.

“If the economy recovers, then a lot of things that were announced in March that end in September – the banks’ repayment holidays, JobKeeper, term lending – will come to an end.

“If the economy hasn’t picked up by a reasonable degree by September, I think some of those things will be extended.

“The [term lending facility] is printed money to the banks for three years, and so if the $90 billion is used up they could presumably extend it, which is basically what the European Central Bank has done.

“The fact that they have extended their cheap funding for many years suggests it’s quite possible that the RBA could do the same thing.”

Low fixed rates could be here to stay for now, Mr Mickenbecker said. 

“The Reserve Bank is supporting lower market interest rates for an indefinite period and this is not likely to change until the economy starts to show it is moving towards full employment, which could be two or three years away.

“We could expect fixed home loan rates to remain relatively low over the next few years before the margin returns to the more usual gap.”

What to remember before fixing your home loan

It’s important to remember that fixed rate loans may provide certainty in repayments and cash flow, but less flexibility than variable loans. 

“This is a period of uncertainty, and the extra flexibility could prove important,” Mr Mickenbecker said.

Fixed loans typically don’t include an offset account or redraw facilities, and have caps on extra repayments. There may be significant break costs, which could outweigh any savings if the need to change arises.

“Even though rates appear to be at rock bottom, it is still possible they could fall further,” Mr Mickenbecker said. “Borrowers may feel remorse that there are better rates than they’ve locked in at.

“You shouldn’t expect that you will always pick the bottom of the market, and keep in mind that the main motivation for fixing your home loan rate is to lock in an affordable repayment.”