Why are fixed rates sometimes lower than variable rates?

The role of the RBA

When the Reserve Bank of Australia (RBA) makes a change to the official cash rate, whether it's an increase or decrease, most home loan customers expect variable home loan interest rates to change as well.

That doesn't always happen though. In fact, during the rate cuts that took place between June 2019 and March 2020 banks didn't pass on every cut. The RBA cut the cash rate by 1.25% over that time and the highest cut passed on by the big 4 was 0.97%.

In recent years, banks have made aggressive cuts to fixed rate home loans instead.

In fact, an analysis of Finder’s database shows the average standard variable rate has been consistently more expensive than fixed rate loans, from 1- to 5-year fixed rate periods, since the end of 2019. And there have been a few periods where the very lowest rate on offer is a fixed rate.

So what causes fixed rates to become less expensive than variable rates? The answer lies in how these different types of loans are funded.

How fixed rate home loans are funded

Fixed rates are funded by global bond markets. This means banks secure funding by selling debt in overseas markets. Fixed rate loans are generally tied to longer-term debt instruments, which usually carry higher interest rates.

The sophisticated investors who are pricing bond markets are betting about the state of the economy in the future compared to today: whether it will be better or worse.

On the other hand, variable rates are largely pegged to the RBA's official cash rate, which is the amount the Reserve Bank charges banks for overnight loans.

Fixed rates essentially reflect what the market believes will happen to the official cash rate (and by extension, the standard variable rate) in the future. If the market anticipates that the official cash rate will rise, fixed rates become more expensive, because lenders assume variable rates are likely to rise in the future. If the market believes the official cash rate (and hence variable rates) will fall in the future, fixed rates become less expensive than variable rates.

Understanding the yield curve

Imagine a standard line graph with just one line. Along the bottom of the graph we start with the cash rate and then go up in years. Up the side of the graph is the 'yield'. The graph is calculating the yield (or the interest rate) of government bonds. In normal circumstances, the line goes up and to the right in a sort of curve or upward slope. What this line is saying is that longer-term securities yield more than lower-term securities.

For example, a 1-year security will have a lower interest rate than a 10-year security.

However, in some circumstances, longer-term debt instruments become lower-yielding than short-term instruments. This happens when the market assumes that yields, or interest rates, are going to fall in the longer term. When this happens the curve goes the other way in what is known as an inverted yield curve.

An inverted yield curve is often cited as a reason for fixed rates falling below variable rates.

It indicates that the market believes rates will be lower in the future than they are now, meaning long-term debt that backs fixed rates becomes cheaper for banks than short-term debt that backs variable rates.

The double-edged sword of an inverted yield curve

When an inverted yield curve occurs, it can represent a good opportunity to fix your loan. It means that fixed rates have become less expensive than variable rates, because banks are able to raise long-term funding for less money than it costs them for short-term funding.

The downside to this is that an inverted yield curve is often the precursor to a recession, which is exactly what happened in Australia in 2020. The inverted yield curve indicates that the bond market is betting that the economy will deteriorate, causing official cash rates to fall.

Australia has seen several inverted yield curves in the past decade:

• The global financial crisis (GFC) was preceded by an inversion of the yield curve between the 90-day bank bill swap rate and 10-year bonds.
• The yield curve inverted once more in 2013, and again in 2018, which preceded fixed rates dropping below variable ones in 2019.
• In 2020, the yield curve inverted to the point where fixed rate loans were up to 0.80% cheaper than variable rate loans.

Expert insight: Don't fix just for the rate

"Fixing is a case-by-case scenario. Should you fix purely for rate? I'd say no, but you could fix to give you a stability and security over repayments. Because, you've got to remember that the majority of banks will not offer an offset account against a fixed rate loan.

The next part is some people may not have the ability to make additional repayments. A fixed rate loan may only allow a certain apportion of the loan.

You may consider fixing part of your loan and keeping part variable. So then the question is, how much do I split that fixed versus variable? That's where you do some number crunching, like you broke at a workout."

Aaron Christie-David

Editorial Review Board

Should I fix my home loan?

With all of this context, should you choose to fix your home loan interest rate when fixed rates are so much lower than variable rates?

The answer to this depends on your individual circumstances, but a good place to start is working out what your goals and plans are.

When deciding whether to fix your rate or not, don't try to "beat the market", because it rarely works. Instead, consider what your goals are and whether a fixed rate might suit you.

The pros of a fixed rate loan are:

• Is much cheaper than a variable loan. Switching from a variable rate to a fixed one could save you hundreds or even thousands of dollars a month, depending on your loan amount.
• Offers a range of options. There are very cheap fixed rate loans on offer for 1, 2, 3, 4 or 5 years.
• Is available from a range of lenders. It's not just the Big Four banks that are offering competitive deals. A range of smaller banks and non-bank lenders have priced their fixed rate loans very cheaply, and many of these banks have more flexible lending policies that suit a wide range of borrowers.

It's important to also consider the potential risks of a fixed rate loan, and these include:

• Less flexibility. When you lock in to a fixed period, you are committed to repaying your home loan at that rate for that period, with no exceptions. If you decide to move house or wish to sell because, for instance, you've ended a relationship, you are not allowed to end the loan without financial penalty.
• Break fees. Speaking of financial penalty, the break fees can be hefty. In a fixed rate loan, the bank calculates how much profit they "lose" by letting you out of the loan early, and that's how much you have to pay in a break fee. It can be thousands, or even tens of thousands of dollars.
• Overall cost. A five-year fixed rate may look very attractive now when an inverted yield curve causes it to become cheaper than the standard variable rate, but variable rates could become cheaper before the five-year fixed rate period ends.

The best reason to lock in your rate is repayment certainty. When fixed rates become less expensive than variable rates, you can lock in a rate that you know you’ll be comfortable repaying for a set period of time.

But in circumstances where variable rates are being cut, you might find yourself missing out on lower rates in the future if you take out a fixed loan.

Frequently asked questions

• Should I fix?

  With all this in mind, should you choose to fix your home loan interest rate when fixed rates dip below variable rates? The answer to this depends on your individual circumstances, but it's always important to examine your motives behind fixing your loan.

  It's unwise to lock in a fixed rate as a wager against variable rates falling further. As was mentioned above, fixed rates become cheaper than variable rates because the market is betting that variable rates will eventually fall even further in the future due to deteriorating economic conditions. The people making these bets are sophisticated investors, and betting against them is a very risky play. A five-year fixed rate may look very attractive now when an inverted yield curve causes it to become cheaper than the standard variable rate, but remember that the reason the yield curve inverted is that the standard variable rate is likely to become cheaper still before the end of the five year fixed rate period.

  The best reason to lock in your rate is certainty. When fixed rates become less expensive than variable rates, you can lock in a rate that you know you'll be comfortable repaying into the future. You'll have the comfort of knowing your repayments will remain the same, regardless of what happens to the standard variable rate. Choosing to fix your loan should be a decision made because you've assessed the repayments and want the certainty that comes from knowing they won't change, not because you think you can outsmart the market."

• Is a fixed rate or variable rate better for my home loan?

  Whether or not a fixed rate or a variable rate is better depends more on your circumstances than anything else. While fixed rates might be cheaper than variable rate home loans at the moment, they also come with less flexibility. You often won't have access to an offset account and will be limited to a certain amount of extra repayments. The good news is that you'll only be fixed for a few years. If you want stability in your home loan repayments, even if variable rates may end up dropping during your fixed rate period, then a fixed rate loan might be better for you.

Written by

Sarah Megginson

Money expert + media spokesperson

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Sarah is the author of How to Raise Rich Kids. With over 20 years of experience in property, finance and investment journalism, she is a trusted expert whose insights regularly appear across television, radio and print media, including Sunrise, Channel 7 News, Bloomberg and Yahoo! Finance. She has previously served as managing editor for Your Investment Property and Australian Broker. Her expert advice has been shared in the media over 4,000 times. Sarah holds a Bachelor’s degree in Communications and a Tier 1 Generic Knowledge certification, which complies with ASIC standards. See full bio

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Sarah has written 260 Finder guides across topics including:

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