With the prime interest rate rising up to 8.25% many prospective home buyers are becoming concerned about how long the low interest rate cycle will last and what the potential impact could be on their home loan repayments and affordability.
The common reaction from home buyers is to begin to mitigate the lack of certainty by considering a fixed rate option over their home loan. The goal is to ensure they can continue to enjoy the benefits of a low interest environment, while hedging against the threat of future increases in interest rates.
The outcome of fixing the interest rate on your home loan is not as straightforward as one might expect. To understand why this is the case, it is important to understand the dynamics of a fixed rate option vs a variable rate.
For example, when deciding to fix your interest rate, your goal is to keep your monthly repayments stable through a cycle of potential interest rate hikes. This puts the bank in a position to have to honour your fixed rate regardless of market fluctuations and therefore the bank will require you to pay a premium for fixing your rate. This premium is typically on average 2% above your default variable rate and therefore your immediate repayments will be higher than most variable rates in the market.
The bottom line is that there is a cost to having the peace of mind of stability, which is commonly not considered or unknown to the home buyers, until they have requested a fixed rate from their bank.
Furthermore, the fixed rate option is not for the entire duration of the home loan and typically expires after a five-year term. At this point you have the option of renegotiating another fixed rate term with the bank or deciding to let your rate float as a variable rate.
To realise the second benefit of the fixed rate option, interest rates would have had to increase significantly beyond the 2% premium that would be charged, during the fixed term period. If not, you would simply have been paying an expensive premium for the right to a fixed installment resulting from your fixed rate.
In contrast, a variable rate is the default rate you will be quoted on your home loan, and it is linked to the prime lending rate at the time of being quoted. This rate depends on several factors such as the quality of your credit score, the loan-to-value and the size of your home loan. Based on these factors, applicants will be given a variable rate that is better or worse than the prime interest rate.
For example, if your variable rate is at prime
minus 0.5% to 1%, this typically indicates that one or all these factors are
present in the profile of your home loan application:
your credit score was assessed by the banks
to be of great quality;
you would be paying a deposit into the property
you are purchasing;
your home loan was R1.5m to R3m; and
negotiations had taken place over the rate.
The converse is true should your variable rate be at prime plus. Therefore, as the prime lending rate shifts or remains unchanged resulting from the decisions taken by the SA Reserve Bank every quarter of the year, your viable rate will shift accordingly.
While this fluctuation in interest rates may appear to be a drawback, home buyers can mitigate the changes in the interest rate by negotiating the best variable rate upfront. This would help you take full advantage of being in a better position than the prime lending rate.
To achieve this, a home loan marketplace such as www.mortgagemarket.co.za can help you compare home loan rates, by giving you an apples-to-apples comparison and then further negotiates your interest rate with banks on your behalf, to get the best rate for your home loan.
An economic climate such as the one we have today is one with slow growth but stable inflation and high unemployment levels. Within this context, it is likely that interest rates will be kept low for the next 18 to 24 months, until an economic recovery begins to gain momentum. Therefore, it's best to enjoy the benefits of a low interest rate environment and save every rand resulting from this decision, rather than paying a premium to fix your interest rate.
