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Pros and cons of a fixed rate

With the prime interest rate at a low that was last seen in the market over 30 years ago, many homeowners may be contemplating fixing the rate on their bond. 

This is particularly appealing to homeowners who are risk averse and want a fixed amount that they can budget for each month, says Adrian Goslett, CEO of RE/MAX of Southern Africa.
 
“Where a homeowner stands financially, along with their appetite for risk, will be the determining factors as to whether a homeowner chooses to fix their rate or opt for a variable or flexi rate. Homeowners who are at their budget’s limit and cannot take the risk of an interest rate increase are probably more likely to opt for a fixed rate than those who have some breathing room in their budget. The security of a fixed rate ensures that the homeowner will not have to deal with any unexpected changes and additions to their monthly expenses for a fixed period of time. However, that said, there are a few elements that a homeowner should think about before they decide to fix their rate,” says Goslett.
 
Generally the interest rate offered by banks is based on the size of the home loan taken by the applicant. In the past, home loan applicants could sometimes get interest rates from the banks that were below prime, however in today’s market, a good interest rate is the prime rate of 8.5%, largely due to the fact that the current level of the prime rate is already remarkably low.  A variable rate is linked to the prime rate and fluctuates with any changes in the rate, resulting in a proportional change in the interest that the homeowner will pay.  If the rate is cut the homeowner will benefit from the cut and pay less, however they will also be subjected to the full impact of any increase in the rate as well.
 
Goslett says that fixing the rate will give homeowners the benefit of knowing what their instalment will be over a fixed period of time, irrespective of the change in prime interest rate, however this does come at a cost. Depending on the agreed terms of the contract, a fixed rate is generally between 1.5% and 2% above the current prime rate to absorb the bank’s risk. “Essentially, a fixed rate will provide the homeowner with a kind of buffer should there be a sharp increase in the interest rate within the time period that their rate is fixed for, although, if there is no increase, the homeowner will be paying more money into their bond than what they would have if their interest rate was linked to the prime interest rate. Given the position of the current economy on a global scale, it is unlikely that any significant interest rate increases will occur in the short term,” says Goslett. “However, that said it is expected that the interest rate will start to increase from the second half of 2014.” 
 
He explains that with the current prime rate of 8.5%, repayments on a bond of R1 million over a 20 year term would cost R8 678.23 per month. If a rate is fixed at 10.5% on the same bond, the repayments will be R9 983.80 per month. This means that for the homeowner to have benefited from the fixed rate, the prime rate would need to have increased by at least 3% to 4% over the term of the loan. 

Goslett says that depending on the financial institution, most fixed interest rate agreements are fixed for a term of between two and five years, with exceptions given by certain institutions. “There are instances when a homeowner will be able to cancel their fixed rate agreement by giving a notice period, however in most cases the contract is only cancelled after the fixed period has elapsed or the property is sold. For this reason it is important for homeowners to carefully read through documentation and explore all options that are available to them before they sign,” he says.
 
While the interest rate is a massive consideration for homeowners, Goslett says that the home loan period is just as important when it comes to a homeowner’s future financial well-being. If a homeowner is considering fixing their rate, another option that could be considered is paying the extra 2% directly into the bond instead which would reduce the bond faster and therefore save on interest.
 
“Paying extra amounts into the bond account will reduce the interest paid on the bond, as well as reducing the term of loan period. It is also a way of providing protection against future interest rate hikes. Just a few hundred rand extra each month could save the homeowner between R100 000 and R200 000 over the term of the loan,” Goslett concludes.


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