Why fixed is not in your interest
WEIGHING UP THE TWO OPTIONS Even in a worstcase scenario, the variable interest rate option comes out tops.
When signing up for a loan, you’re usually quoted an interest rate relative to the prime rate, for example, prime plus 0.5%.
This is known as a variable rate, as the rate varies according to the prime lending rate.
Sometimes you’re offered a fixed interest rate.
Here, the rate won’t change for the loan duration (or, if the loan’s longer than five years, the fixed rate’s usually fixed for a five-year period).
With a fixed rate, even if the prime lending rate changes, the repayment amount remains unchanged.
It’s pretty much always better to choose a variable interest rate instead of a fixed rate.
At the beginning of a loan, only a small amount of the repayment value goes towards the principal debt, the rest goes towards interest.
So it’s in your “interest” to have a lower rate at the start of a loan rather than at the end.
This is where the problem with a fixed interest rate comes in.
The fixed rate will almost always be higher than the variable rate.
When presenting a fixed interest rate option, banks reason:
“The fixed rate means your monthly payment won’t change, even if interest rates rise….” True. But they don’t tell that if the interest rate did rise, even aggressively, it’ll take a few years for the value of the variable rate to increase and overtake the value of the fixed rate.
By then, 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.
As far as rising interest rate environment goes, consider someone taking a R100 000 loan over five years. Their options are a variable rate of prime + 0.5% (currently 10.75%) or a 12.75% fixed rate.
Let’s assume the Reserve Bank raises the repo rate every six months by 0.5% for the loan duration.
The variable rate will move from 10.75% at the start of the loan to 15.25% by the last payment.
Even with the extremely aggressive increases in prime lending rates, 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.
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 (figure 1) how the big savings in instalments at the start of the loan are only partially offset by the additional costs at the end.
Source: This article was republished from http://www.stealthywealth.co.za