Term Premium and Fixed Rate Pricing

Key takeaways

• Fixed rate is roughly expected average short rate + term premium + lender margin.
• Term premium compensates for interest rate risk over the term, and it varies.
• A term premium can be negative when investors want duration badly enough.
• Fixing is insurance against variability, not a prediction contest.

What is term premium?

If markets only cared about expected rates, a five-year rate would simply be the average of expected one-year rates over five years - the pure expectations hypothesis. It never works out that way, and the residual is the term premium.

The premium compensates the lender for bearing risk over a long horizon: inflation could turn out higher than expected, the path of policy could surprise, and the money is committed either way. That compensation is a price, and prices move.

It also explains a common misunderstanding. When a borrower says "the five-year fixed rate implies the RBA will hold rates at that level for five years", they are attributing all of the rate to expectations and none to premium.

How does the premium reach your fixed home loan?

Through the swap market. Lenders hedge fixed-rate lending using interest rate swaps, so the swap rate at the relevant tenor is the wholesale input, and the term premium is already embedded in it. The lender then adds its own margin for credit risk, capital, operating costs and competitive positioning.

Two of the three have nothing to do with your loan. That is why fixed rates sometimes move sharply in a week when the cash rate has not changed at all.

Does this change how you should decide about fixing?

It should change the question. "Will I be better off fixed?" is a forecasting question you cannot answer. "How much variability can my budget absorb?" is a question you can answer, and it is the one that actually determines whether fixing is appropriate.

Reframed that way, the term premium is the price of the insurance. On average, over long periods, paying a premium means the insurance costs something - which is exactly what insurance does. Whether it is worth buying depends on the consequence of the risk for you, not on the expected value of the trade.

Three practical points remain: fixed loans usually restrict extra repayments and offset arrangements, break costs on early exit can be substantial, and a split can buy partial certainty without committing the whole balance.

Frequently asked questions

Why is the 5-year fixed rate higher than the variable rate?

Usually because of term premium - the compensation for committing funds over a long horizon - plus the market's expectation of the path of the cash rate. A higher long fixed rate does not necessarily mean the market expects rates to rise that far.

Can term premium be negative?

Yes. When investors have strong demand for long-duration assets, or expect rate cuts, the premium can compress or turn negative, producing an inverted curve where long rates sit below short rates.

Does fixing mean I am betting against the bank?

It is better understood as buying certainty. The bank hedges its exposure in the swap market rather than taking the other side of your view, so fixing transfers rate variability rather than creating a bet.

Why did fixed rates move when the RBA did not meet?

Fixed rates are priced from swap and bond markets, which reprice continuously on inflation data, global yields and shifts in expectations. They do not wait for an RBA meeting.

Related reading

• How Swap Rates Determine Your Fixed Home Loan Rate
• The Yield Curve: What Bond Markets Say About Rates
• Fixed vs Variable in a Hiking Cycle: The 2026 Decision Framework

Sources

• The term structure of interest rates — Reserve Bank of Australia
• Statement on Monetary Policy — Reserve Bank of Australia