Pros and cons of a variable vs fixed rate loans
The path to securing the home of your dreams is a winding one, and regardless of whether you're a first time buyer or an experienced investor looking to expand your property portfolio, you'll probably make some wrong turns along the way. However, with some diligent research and perhaps getting some guidance from a professional, you'll be better able to plot your course and navigate your way to financial security.
One of the biggest forks in the road you'll likely come across in your journey is your choice of home loan. Choosing between variable and fixed rate 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.
Both loans have their pros and cons, and what is right for one buyer may not necessarily be the best option for another. To help you make a more informed decision, we've broken down the key attributes of each type of mortgage:
What are the advantages of variable home loans?
Variable home loans are more flexible but provide less certainty.
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, as the Australian Securities and Investments Commission (ASIC) noted, one of the key benefits of taking out a variable home loan is that you're able to make extra repayments on top of your scheduled instalments 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 favour. This is because interest rates on variable mortgages are tied to the official cash rate, which the Reserve Bank of Australia (RBA) sets monthly. As it stands, the cash rate is set at a record low 2 per cent, with Governor Glenn Stevens explaining that the RBA hopes the accommodative conditions will support borrowing and spending, and help the economy grow.
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.
As noted, variable home loans are generally more flexible than fixed alternatives, and often come some useful features that can be used to make paying off your loan that much simpler. The Australian Finance Information Centre explained that under some arrangements, you may be able to leverage redraw facilities or open an offset account, both of which - when used wisely - can be handy financial tools.
What are the disadvantages of variable home loans?
The number one drawback of variable home loans is the level of financial uncertainty associated with them. Because variable home loans are 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.
What are the advantages of fixed home loans?
The primary benefit of taking out a fixed rate home loan is the greater sense of certainty it provides. Under this arrangement, the interest on your mortgage is locked into the rate it was when the loan was first approved, meaning that even if your lender increases the interest rates, your repayments will be unaffected.
On October 14, Westpac increased variable rates by 20 basis points.
This could prove to be a valuable asset in the years to come, with news.com.au reporting that some banks are making moves to increase rates on their variable loans. Westpac, for example, increased variable rates by 20 basis points on October 14, and some experts are seeing it as a sign of things to come.
Peter White, chief executive of the Finance Brokers Association of Australia, predicted that more lenders will follow Westpac's lead.
"We've had 4-5 per cent interest rates when probably we should have been having 7 per cent," said Mr White, as quoted by news.com.au.
"My instinct is saying it probably is the end of the good times. We may not be getting back to the dark old days of 18.5 per cent in the 70s and 80s, but at some point in the next five years normal rates will be around that [7 per cent] mark."
If Mr White's predictions come true in the near future, those who lock into today's low interest rates may be able to make significant savings on their mortgage repayments.
However, there are so many influencing factors that go into shaping the economy that it's almost impossible to accurately forecast which way the market will shift. In fact, research suggests that you have exactly the same chances of beating the market as if you simply flipped a coin.
A comprehensive analysis by Canstar found that over the last 20 years, around 50 per cent of borrowers who took out a fixed rate home loan saved more money than if they'd taken out a variable mortgage.
So, with a healthy dose of luck, you may be able to use a fixed rate mortgage to beat the market, but by no means is it a certainty.
What are the disadvantages of fixed home loans?
The certainty of a fixed home loan allows you to set an accurate budget.
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.
As ASIC surmised, fixed rate mortgages typically do not allow you to make extra repayments - or, if they do, you may face a hefty fee. This restriction essentially limits the speed at which you can pay off your home loan, in some scenarios making it more expensive than a variable alternative.
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.
To sum it up, the key differences between fixed and variable home loans are largely centred on certainty. If you want more freedom and are comfortable with the greater economy dictating your interest repayments, a variable mortgage may be the way to go. Alternatively, if you need the ability to set a budget and make mortgage repayments of a consistent amount, a fixed home loan may be the superior choice.