Pros and Cons of Fixed Rate Vs. Variable Rate Home Loans

If you are in the market for a property and are looking to take out a home loan to help you afford to buy, you will likely have heard the terms ‘fixed rate’ and ‘variable rate’ used in relation to mortgages.

Having a fixed rate means that your loan will have an unchanging interest rate for a period of between 1 to 5 years depending on your lender and loan conditions. Having a variable rate means that the interest rate on your loan is liable to change over time.

What Is a Fixed Rate Home Loan?

A fixed rate home loan is a home loan which features an established period of time during which the interest rate that will need to pay on your outstanding debt cannot increase or decrease. These fixed rate periods range from 1 to 5 years, with 3- and 5-year periods being the common choices amongst finance customers.

To understand why fixed rate loans are potentially useful, it is first necessary to understand how interest rates work more broadly. Australia’s reserve bank sets interest rates in order to regulate the national economy, and will decrease or increase rates depending on how much access to credit the economy needs overall.

When rates are altered, banks and other financial institutions must pay more or less interest to the reserve bank for the credit which they choose to access. These costs are then passed on to customers in order to maintain those institutions’ healthy operating margins.

Essentially, opting for a fixed rate home loan is a reflection of one’s view as to whether or not interest rates are likely to change in the near future. Should the borrower believe that rates will likely fall in the coming years, then a fixed rate would be potentially detrimental to their finances. Should the borrower believe rates are likely to rise, then a fixed rate can be a valuable feature.

What Is a Variable Rate Home Loan?

Put simply, a variable rate loan is the opposite of a fixed rate home loan. It is a loan that does not include a fixed rate period, meaning that interest rates applicable to outstanding debt are free to rise and fall depending on the reserve bank’s determinations of where rates should sit.

By choosing to take on a loan with a variable rate, a borrower is assuming that rates are unlikely to significantly increase in the coming years, or that rates are in fact going to decrease, thereby saving the borrower some of their future interest expense.

Often variable rate loans are offered with other possible features to add to the loan, including offset accounts, the ability to make greater advance payments towards your mortgage, or draw-down facilities- the ability to draw down equity on your home in exchange for credit. These features make the variable rate option more enticing for many borrowers.

Fixed Rate Vs. Variable Rate Home Loans

Before you go ahead with committing to a home loan, make sure you have a good understanding of the implications of fixed or variable rates on your future loan.

PROS

You are protected against future interest rate hikes, saving yourself money on higher interest payments.

You can budget more exactly, knowing how much your monthly interest payments will be far in advance.

At the end of your fixed rate period, you can choose to commit to another fixed rate period, or revert to a variable rate structure.

You will be able to take advantage of future interest rate cuts in order to save on interest payments.

You will be able to refinance your mortgage at any time of your choosing, as well as draw down equity from your property.

Many lenders offer customers with variable rate loans the option to add extra features to their loan such as the ability to make easier early repayments.

CONS

You miss out on the benefits of any possible decline in interest rates.

You might allocate more money in your budget to interest payments than would have been necessary in the event that rates fall.

If rates fall, you will need to wait for your fixed rate period to end before adopting variable rates.

If interest rates rise, you will need to accept this new rate and your interest payments will increase.

If you choose a variable rate in order to maintain greater freedom of choice, you might ultimately find that you don’t ever exercise these options, but still took on the risk of making greater interest payments.

It is possibly that if rates rise high drastically, the benefits of these extra loan features are still offset by increased interest payments.

Top Tips for Getting the Best Home Loan

Getting the best home loan, regardless of whether you wish to find a fixed or variable rate loan, often comes to a few key factors. These are as follows:

Saving more for your deposit

By taking a little bit longer to save a greater amount for the initial deposit on your home, you will be subject to less interest expenses throughout the duration of your mortgage and will pay less (or potentially even avoid paying) lenders’ mortgage insurance.

Have a strong financial history

Ensuring that you can prove to have been saving with discipline and keeping your superfluous expenses to a minimum will show prospective lenders that you lending you money is a safe investment on their part, and that you should enjoy more favourable loan conditions than those who are considered to be a greater credit risk.

Understanding your own needs

Because everybody’s idea of the ‘best’ home loan is different, the only way you can get the best home loan for yourself, is by actually understanding what you want to get out of it. By making sure you are familiar with different loan types and features, you can ensure that you ultimately end up with a loan that is best suited to your needs.

More Questions About Fixed vs Variable Rate Home Loans?

Choosing between fixed and variable rate loans is an important decision. Here are answers to more questions which could help you on your way.

When is it usually a good time to fix home loan interest rates?

It is not possible to say for certain when it is the best time to fix home loan rates, because the reserve bank’s interest management cannot be predicted, however there are other factors that can help to inform your decision apart from rates themselves.

For example, if you are planning on drawing down some of the equity you own in your home or refinancing your mortgage in the next few years, this will probably mean that you would not want to fix your loan interest rates, as you will want to maintain the option to utilise these features which are available to you as a part of your variable loan.

What is the danger of taking a variable rate loan?

The risk in taking on a variable rate loan, as mentioned above, is that the reserve bank can choose to increase interest rates and in turn, your lender can determine that they must pass this increase in rates on to you. This will result in you needing to pay an increased amount for your ongoing interest repayments.

This is undesirable for many people as their property investment strategy requires forward planning and budgeting based on predictable, regular expenses.

Why are fixed mortgage rates lower than variable rates?

Fixed rate mortgages are currently lower than variable rates because lenders predict that further interest rate cuts are a strong possibility in the future, meaning it is in the interest of lenders to fix interest rates at current levels.

Which is better, a fixed rate or variable rate home loan?

Which of these two is ‘better’ is ultimately a matter of your needs and personal view of Australia’s economic outlook. If you are looking to take on a loan which will allow you to easily manage your debt with regular, predictable payments, then a fixed loan might be better for you. If, on the other hand, you would like the option to make early repayments and access to an offset account in order to try to reduce your interest costs, then this might be your preferred option, provided you are willing to ride the ebb and flow of interest rates moving forwards.

Can I extend the fixed rate period on my mortgage after the initial period has come to an end?

Yes, it is possible to re-fix the rate on your home loan at the end of the initial fixed rate period, however the new fixed rate will be a reflection of the updated interest rate environment and may not be as favourable to you as your previous rate.

What if I want to exit my fixed rate period early?

While banks will not prevent you from exiting your fixed rate period early in order for you to switch your loan to a variable rate, doing so will incur a ‘break cost’, which is equal to the cost that the bank must incur in order to ‘bridge’ the change in your interest rate. There is no way around paying this fee, and this should be factored into your decision making when opting for a fixed rate.

Is there any way I can get the benefits of both a fixed and variable rate?

There is no way to enjoy the best of both arrangements absolutely, but many lenders do offer a ‘split loan’, which allows you to fix the interest rates on one portion of your loan while allowing the other portion to remain variable. This arrangement allows you to utilise some of the features of a variable loan such as an offset account, while also hedging against economic volatility in the form of your fixed rate loan segment.

Pros and Cons of Fixed Rate Vs. Variable Rate Home Loans

Comparing the Benefits of Fixed Rate and Variable Rate Home Loans.