Fixed rate versus floating rate loans

The textbook reason for using fixed rate loans is to gain certainty.

For example, someone fixing their mortgage for five years knows the exact repayments over that period, regardless of what happens with interest rates.

Like insurance, that certainty can be worth paying a premium for, but you don’t always have to.

Those who have just arrived on the housing ladder, or households on one salary, are big users of fixed rate loans. They have often borrowed so much that their tolerance for interest rates rises is low.

Early on in life people may also have less confidence in their ability to forecast the direction of interest rates.

Fixed rate loans are inflexible. If you want to ‘‘break’’ the term, there can be a big fee to pay to ‘‘compensate’’ the bank for lost interest. Break fees can be large when interest rates are rising. When they are falling, they can be low or zero.

By contrast, floating rate loans bring flexibility.

They are more risky because the rates of interest rise and fall in line with movements of the official cash rate.

Floating rates are often used by borrowers who believe interest rates will fall, providing them with a mechanism to reduce their interest costs.

They are also favoured by those with large discretionary incomes who have their salaries paid directly into a revolving mortgage facility to reduce the loan balance on which interest is charged.

Floating rate loans can also be a lazy default position for people with little left on their mortgage to repay, as they become less sensitive to interest rate changes.

Over the long term, floating rate loans have had higher interest rates.

Data from the Reserve Bank shows the average two-year fixed rate loan from the banks has been 7.3 per cent since 1998. In the same period the average floating rate has been 7.6 per cent, but it has also touched levels of over 10 and 11 per cent, something fixed rates have not done.