Pros & cons of fixed vs variable rate home loans
One of the biggest forks in the road you'll likely come across in your journey to purchase a new home is the home loan interest rate type. Choosing between fixed or variable home loans is no easy feat, but nevertheless it's important to gain a strong understanding of how each type of mortgage could affect you - particularly when you consider how much capital you're investing into the purchase.
Fixed rate home loan
A fixed interest home loan is guaranteed not to change for the length of time you have agreed to fix it for - typically anywhere from 1 to 5 years. At the end of your fixed term, you can choose to re-fix your loan at the new offered rates or roll onto a variable rate loan.
Pros and cons of fixed rates
The primary benefit of taking out a fixed-rate home loan is the greater sense of financial certainty it provides.
Under this arrangement, the interest on your mortgage is locked into the rate that you agreed to for a period of time e.g. three years. This means that even if your lender increases their interest rates during that time, your fixed rate and repayments will be unaffected. This can be helpful, particularly for first homeowners who are adjusting to making regular repayments.
Some fixed rate products will allow a limited amount of additional repayments to be made without incurring a penalty, but if you plan to make additional repayments to your fixed rate loan, it is important to understand what this limit is first.
Locking in a fixed rate
You may come across a great fixed rate deal when you’re applying for a home loan, however that doesn’t guarantee that you’ll get that fixed interest rate when you settle on the property.
The fixed interest rate that will apply to your loan is the fixed rate offered by the lender on the day of settlement, not at the time of loan application.
Locking in your fixed rate with a ‘Rate Lock’ can be a useful tool at your disposal to prevent any rate shocks from impacting your borrowing power.
With interest rates on the rise, here at loans.com.au, we offer the ability for customers to lock in a fixed home loan rate and avoid being caught out by potential interest rate headaches.
The certainty of a fixed home loan allows you to set an accurate budget. However, the inflexible nature of a fixed home loan is both a blessing and a curse.
It provides you with a strong sense of certainty, even when the economy is going through tough times, but it also offers little in the way of choice and freedom.
The downside to your rate being locked in for a length of time occurs when interest rates are dropping around you, meaning that if you were on a variable rate you would be paying less interest than what you are on a loan that was fixed at a higher rate.
The penalties for making additional repayments beyond the allowed limit can be harsh if you unknowingly make more repayments than is allowed. Fixed-rate mortgages typically do not offer features like a redraw facility or offset sub-accounts. In addition, if you make adjustments to your loan or sell your home within your mortgage term, you may also have to pay expensive break fees, often to the tune of thousands of dollars.
Variable rate home loan
A variable rate home loan is a type of loan where the interest rate is a floating rate where the interest rate may go up or down over the life of the loan. When this happens, your monthly repayments will also change which means the interest rate may go up or down over the life of the loan. When this happens, your monthly repayments will also change.
The price of a variable interest rate loan will change continually throughout the life of the loan as a result of external factors, including the lender’s funding costs, the Reserve Bank’s official cash rate and the economy as a whole.
Pros and cons of variable rates
The main advantage of a variable interest rate is its flexibility. With a variable rate loan, you can make extra repayments towards your mortgage which in turn will help you pay off your loan sooner.
The vast majority of people in Australia choose to finance their home with variable home loans, largely due to the freedom and greater number of options they offer. More than merely providing a higher level of convenience, this flexibility can actually allow you to save substantial amounts of money over the course of your mortgage. How? Well, one of the key benefits of taking out a variable home loan is that you're able to make extra payments on top of your scheduled installments with no penalty. By doing so on a regular basis, you may be able to drastically cut down the length of your mortgage, reducing the overall amount of interest you'll need to pay and ultimately scoring a better return on your investment.
In addition, under a variable loan arrangement you may be able to further strengthen your financial position if market conditions happen to swing in your favor. If interest rates go down, so will the amount of interest you are charged each month. If the cash rate drops and your lender decides to pass the changes on to its customers, you'll have less interest to pay off. On the other hand, if the rate goes up, your repayments will increase accordingly.
Some variable loan products will offer additional features like redraw facilities or loan offset sub-accounts, both of which - when used wisely can be handy financial tools to shaving time off your home loan.
The number one drawback of variable home loans is the level of financial uncertainty associated with them. Because variable home loans are often tied to the cash rate, the amount of interest you need to pay is more or less at the mercy of wider economic conditions outside of your control.
This means that your required repayments will probably fluctuate quite significantly over the course of your mortgage, making it challenging to set - and stick to - an accurate budget.
Depending on your personal circumstances, it can be difficult to choose between fixed or variable home loans. To solve this indecision, lenders can offer the best of both worlds in the form of a split loan.
In essence, a split loan allows you to ‘split’ your total borrowing amount into two separate loans - one fixed and one variable. For example, if you had a $500,000 loan you could split that into a variable $250,000 loan and a fixed $250,000 loan.
The main drawback of a split loan is that if you pay it out while part of your loan is fixed, the fixed portion will likely incur fixed rate break costs The variable portion of the loan will allow you to make extra repayments to reduce your loan balance, however the fixed side can still impose penalties for early repayments.
Which to choose?
Fixed rate, variable rate, and split loans all have their individual pros and cons, and what works best for you will depend on your individual financial circumstances. Is the stability of a fixed rate your most important concern, or do you want the option to make additional payments to your home loan as your income rises? These are key questions to consider when it comes down to making your decision.
For more information on what type of loan would best suit you and your financial circumstances, or to lock in a fixed interest rate, talk to one of our lending specialists to find out if you qualify today.
About the article
As Australia's leading online lender, loans.com.au has been helping people into their dream homes and cars for more than 10 years. Our content is written and reviewed by experienced financial experts. The information we provide is general in nature and does not take into account your personal objectives or needs. If you'd like to chat to one of our lending specialists about a home or car loan, contact us on Live Chat or by calling 13 10 90.