When signing up for a loan, you are usually quoted an interest rate relative to the prime rate. For example, you may be offered a rate of prime plus 0.5%. This is known as a variable rate – because the rate will vary according to the prime lending rate.
Sometimes you are also given the option of a fixed interest rate. With this option, the rate will not change, and is fixed for the duration of the loan (or, if the loan is longer than five years, then the fixed rate is usually fixed for a period of five years). With a fixed rate, even if the prime lending rate is increased or decreased, the repayment amount will remain unchanged.
So if you are presented with the option of a fixed rate or a variable rate, which one should you go for?
I am putting the answer right near the top of the article, so that if anyone is looking for the short version, here it is:
It is pretty much always better to choose a variable interest rate instead of a fixed interest rate.
The bottom line is this – at the beginning of a loan, only a small amount of the repayment value goes towards the principal debt. The rest of the payment goes towards interest. So it is in your interest (see what I did there?) to have a lower rate at the start of a loan rather than at the end of the loan.
And this is where the problem with a fixed interest rate comes in …
The fixed interest rate you will get is almost always going to be higher than the variable interest rate you would get. One of the big cheeses over at bond originator Ooba, Kay Geldenhuys, explains it thus: “Banks hedge their own risk of the interest rate going up by only allowing the consumer to fix their repayments at a rate higher than the one they were paying before.”
So a fixed rate means you will have a higher interest rate at the start of the loan – the part where it hurts the most!
Okay now I can hear you shouting the same reasoning the lenders use when presenting a fixed interest rate option: ‘The fixed rate makes you secure in the knowledge that your monthly payment will not change. Even if interest rates rise, your monthly repayment amount will be unaffected.’
And yes, this is true. But what they fail to tell you is that if the interest rate did rise, even aggressively, it will take a few years for the value of the variable rate to increase and overtake the value of the fixed rate. By the time that happens, the damage caused by the higher fixed interest rate at the start of the loan is only partly offset by the gains of the lower fixed interest rate at the end of the loan.
That may sound complicated, so I think it is time for some examples …
Fixing your interest rate in a rising interest rate environment
Consider someone taking out a R100 000 loan over five years (60 months). They get two options – a variable rate of prime + 0.5% (currently equal to 10.75%) or a fixed rate of 12.75%.
Let’s start off by loading the dice heavily in favour of the fixed interest rate option. Let’s assume that the South African Reserve Bank jacks up the repo rate every six months by 0.5% for the duration of the loan. In other words, the variable rate will move from 10.75% at the start of the loan all the way up to 15.25% by the time the last payment is made (we are playing into the usual reason given for fixing your interest rate: that the interest rate can rise and you can end up on a higher interest rate.)
The result of this scenario is summarised below:
|Fixed interest (12.75%)||Variable interest (starts at 10.5% and increases by 0.5% every six months until 15.25%)|
|Total repaid||R135 751.80||R134 184.67|
|Total interest||R35 751.80||R34 184.67|
You can see that even with the extremely aggressive increases in the prime lending rate – resulting in the variable interest rate ending up a full 2.5% higher than the fixed rate – the variable interest rate option still ends up costing around R1 500 less!
Now let’s look at the monthly instalments for each scenario.
You will notice that, in the beginning, the instalments for the variable option are much lower than the fixed option (R2 137 versus R2 237). The variable interest rate instalments then get bumped up with each interest rate hike, until it overtakes the fixed interest rate repayments.
But visually, you can see how the big savings in instalments at the start of the loan are only partially offset by the additional costs at the end.
Or to put it another way, the next chart shows the interest paid per month for the variable and fixed interest rate loans.
Again, you can see the damage done by the higher fixed interest rate at the start of the loan. The lower interest paid at the end of the loan is not enough to catch up!
So, even in a bit of a worst-case scenario, the variable interest rate option comes out tops.
I want to address one last counter-argument in this scenario – the repayment amount at the end of the loan is higher for the variable interest rate option (R2 281.86) than for the fixed interest rate option (R2 262.53). This can cause someone to overspend on their budget, right?
Okay, let me quickly smash this one out of the park:
- If an extra R20 (or even R200 for that matter) a month on debt repayments is going to sink your budget, you are over-extended and should not be taking the loan in the first place!
- By the time the variable interest instalment overtakes the fixed interest instalment, three years would have passed. In that time you should have received a few inflation-related salary increases (heck, if you were smart enough to choose the variable interest option, I would say you would have even got a promotion by then).
Okay, I think that’s enough about the rising interest rate scenario. But because I don’t think it’s fair to only check the worst-case scenario, let’s see what happens if interest rates just plod along sideways, or better still, go in your favour?
Fixing your interest rate in a flat interest rate environment
Using the same parameters as the first example (a loan of R100 000 over 60 months with a fixed rate of 12.75% or a variable rate of prime +0.5 (so 10.75%) let’s see what happens if the prime rate remains unchanged. I think the result is obvious (a loan at 12.75% is going to be way more nasty than a loan at 10.75%), but here are the actual numbers:
|Fixed interest (12.75%)||Variable interest (starts at 10.75% and remains at 10.75%)|
|Total repaid||R135 751.80||R129 707.72|
|Total interest||R35 751.80||R29 707.72|
In a scenario where rates remain unchanged, you would have been R6 000 better off by going with a variable rate.
Fixing your interest rate in a falling interest rate environment
Finally, let’s see what happens for that same loan if the prime interest rate decreased. Let’s say the variable interest rate starts at 10.75% and then the prime rate is decreased by 0.5% every year.
|Fixed interest (12.75%)||Variable interest (starts at 10.75% and decreases every year by 0.5%, until 8.75%)|
|Total repaid||R135 751.80||R126 381.83|
|Total interest||R34 225.92||R26 381.83|
You would have been over R7 900 better off by going with the variable rate! Win!
Time to hit the turbo
Here is something else to consider about the whole fixed-versus-variable decision.
If we consider our loan example, the two options were:
Fixed at 12.75% – starting instalment R2 237
Variable at prime + 0.5% – starting instalment R2 137
The fact that you even considered the fixed option, means that you could afford an instalment of R2,237. Yes?
But since you know that the variable interest rate is the way to go, your instalment is now only R2 137.
Time to hit the turbo button on that loan – take the extra R100-or-so saving (you could afford the higher instalment remember?) and pump it back into the loan. This will save you even more interest and reduce the loan term by a few months.
Score again on the variable interest side!
So when should you fix your rate?
In the above examples, it was clear that going with the variable interest rate was the better option in a rising, flat and falling interest rate environment. So is there ever a time to fix your interest rate?
I suppose a case could be made if the fixed rate was only slightly above or even below the variable rate quoted (I don’t think this has ever happened). But even then, I would be very hesitant.
Always remember, lenders are not in the business of messing themselves over. If they are offering a fixed rate, you can be damn sure that the odds are weighted in their favour (and not yours). The bank is taking on some risk by fixing your rate, and you can be sure that they expect to be rewarded for sticking their neck out. Your fixed rate will always reflect this extra reward they expect.
Finally, one last quote to put the final nail in the fixed-interest-rate coffin (found in this article on Investopedia.com):
“It is important to note that studies have found that over time, the borrower is likely to pay less interest overall with a variable rate loan versus a fixed rate loan.”
Just go with the variable rate!
This article was republished with permission from Stealthy Wealth. The original can be found here.