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The question of whether to fix your interest rate or not is a common one. To understand what questions you should be asking yourself you first need to understand what is happening when you fix your interest rate.

What the Bank does

When you ask the bank to fix your interest rate for a period of time the process that goes on behind the scenes is more complex than you might think! In simplified terms it can be summarised as follows:

The first thing you need to understand is that the interest rate the bank offers to fix your loan at is set by a whole market behind the scenes. In this market people take all the economic and business information they can and try and predict where interest rates will go over specific periods of time. They then work out what this translates to in terms of an average rate for the period, also allowing for inflation. This is the interest rate the market trades at. It also represents the rate that the banks can obtain the funds you need to borrow at a fixed rate. The bank then adds a margin for profit and a margin of error (because lets face it – the banks want to make sure they make their profit!). After all this the bank arrives at the rate that they are willing to offer you! Balancing all this is the reality that there is strong competition between the banks for your loan and this generally keeps their margin for profit fairly tight!

What does this Mean to You

In simple terms if you fix your interest rate there is a strong probability that you will end up paying slightly more over that time than if you stayed at variable rates as the market includes a margin for error in their favour. What you have bought is peace of mind and the ability to plan your cash flow. That is not to say that sometimes the market and thus the banks do not get it wrong to your benefit.

So what happens if I need to break my fixed rate loan?

When you break your fixed loan period there is a fair amount of work involved so straight away there is an admin charge. This varies from institution to institution.

The second factor is whether interest rates for the remaining period of time have moved in your favour or not. For example if you fixed at 8% and the variable rate is now 10% that bank is better off with you out of the fixed rate loan and there will be no extra charge to you other than an administration charge. However if you fixed at 8% and interest rates are 6%, then the bank loses because they have an arrangement in the market at the higher rate. It will cost the bank to get out of their arrangement and they will pass that cost on to you. Depending on how much interest rates have moved against you this amount could be quite large.

In summary each bank has a formula for working out the cost of breaking a fixed rate loan. Before you ever break a fixed loan it is a good idea to call your bank and they are obliged to tell you exactly what the break cost of the loan will be at any particular date you nominate. As this figure can be quite large it is important to know when you are making any financial decisions.

In Summary

Given you are happy to stay with your loan for the relevant fixed time period there are only 2 reasons why you would fix your interest rate over staying on a variable rate:

Questions to Ask yourself before Fixing

• Would I prefer to have a fixed payment instead of worrying where interest rates are going?
• Are you happy to stay in the loan for the fixed period at the risk of additional cost should you need to repay it early