Choosing between a fixed or variable rate home loan is a common dilemma for many borrowers. We look at what they are and outline some of the key advantages and disadvantages of both to help you decide which option is suitable for you.
What is a fixed rate home loan?
A fixed interest rate home loan is a home loan with the option to lock in (or ‘fix’) your interest rate for a set period of time (usually between one and five years). One of the main advantages of this is cash-flow certainty. By knowing exactly what your repayments will be, you’ll be able to plan ahead and budget for the future. This factor often makes fixed rate home loans very popular for investors over the first 2-3 years that they own a property for.
Another reason why a fixed rate may be a good option for you is that any interest rate rises won’t affect the amount of interest you will have to pay. However, if interest rates drop, you might be paying more in interest than someone who has a variable rate home loan.
It’s also important to note that often additional loan repayments are not allowed with fixed-rate loans (or only allowed if you pay a fee). Because of this, the ability to redraw is also frequently not offered on a fixed rate loan, effectively reducing the flexibility of the loan.
What is a variable rate home loan?
A variable rate home loan is a home loan where your interest rate will move (or ‘vary’) with changes to the market. This means your interest rate can rise or fall over the term of your loan.
Variable home loans also have appealing features like the ability to make extra repayments (often at no extra cost) to help you pay off your loan sooner and save you interest. Another advantage can include unlimited redraws (where you ‘draw’ back out the extra repayments you made).
Variable rate loans are more uncertain than fixed interest rate loans. This can make budgeting for your interest payments more difficult because you have to take into account potential rate rises. If you aren’t prepared, you could have trouble keeping up with repayments.
Can I split my loan?
A popular home loan option is to split your loan between fixed and variable. This allows you to lock in a fixed interest rate for up to 5 years on a portion of your loan, while the remainder is on a variable rate. Effectively, this can help you ‘hedge your bets’ on an interest rate rise or cut, minimising the risks associated with interest rate movements. At the end of the fixed rate period, you have the choice of fixing that portion again (at the current market rate for fixed interest) or simply letting it revert back to the same variable interest rate that you are paying on the balance of your loan.
Interest rate risk
Trying to predict home loan interest rates can be a risky business, but in effect, every homeowner is doing this whether they decide on a variable interest rate or fixed. If you’re new to the market or worried about interest rates going up sooner rather than later, then fixing all or a portion of your loan could be a good strategy. A quick look at what’s on offer in the market for 3-year fixed rates at the time of writing shows that the premium you’d pay to fix your rate could be around 25 to 50 basis points (0.25 to 0.50 percentage points). Our last RBA rate change was back in August 2016, so banks charging a higher price on a fixed rate could be them anticipating that the current variable rate is going to go up by this in the next 3 years and could possibly continue into the medium to long-term.
Home loans depend on your individual circumstances, attitudes and motivations. If you’re new to the market and don’t feel comfortable taking any risks then you may want to consider choosing a fixed rate home loan, much like many new property investors do for the first several years of their investment property loan. If you’re more confident with interest rates and are happy to be paying what the great majority of other lenders are paying (relatively speaking), you may find a variable rate home loan is more suited to your needs.