Trying to make sense of the mortgage jungle? Not sure if a fixed rate or variable rate home loan is right for you?
It’s important because the interest rate you pay has a big impact on your home loan repayments over time. Here we'll explain the difference between fixed and variable rate home loans so you can decide which works best for you. Key points we cover include:
Before we get into the essential differences between fixed and variable rate home loans, it’s worth getting back to basics and outlining what interest rates are and how they are calculated.
The interest rate is how your lender makes a profit from loaning money to you.
Banks and other lenders base the interest rate on your home loan on the rate they have to pay the Reserve Bank of Australia (RBA) who is loaning them money. This is called the RBA's cash rate. It’s a long chain of money lending with the RBA at the top of the pile.
When you start researching home loans you'll see the interest rate listed next to the name of the loan as a percentage, like this: 2.09% p.a. The p.a stands for per annum, which is the interest rate you will pay on the loan over a year.
You actually want to look for the comparison rate, which includes the interest rate as well as all the fees and charges you have to pay with the loan. With these added on, the actual rate is a little higher, for example: 2.12% p.a. comparison rate.
When you take out a loan with a lender there are two components:
When you make your regular mortgage repayments, they go towards these two components. The interest rate has the greatest impact on your monthly repayments and on the overall cost of your home loan.
Example: here are two home loans, one with an interest rate of 2.33% vs a rate of 3.0%. Our calculation is based on a 25 year loan term (or length) for a loan of $500,000.
In this case, if you took the loan with the 3.0% p.a. rate you would have paid $51,162 more in interest over the life of the loan.
As you can see, a small difference in interest rates adds up over time, so securing a lower rate can help save you thousands of dollars in the long run.
If you're paying principal and interest, your monthly repayments pay a portion of the original amount borrowed (the principal) as well as the interest charged on the loan. This is the fastest way to pay off your home loan, although you need to be sure it suits your specific circumstances.
If you choose an interest-only loan, your repayments will only pay off the interest on the loan, not the principal, for a set period—often between 3 and 5 years.
This can be helpful for home buyers looking to benefit from lower repayments in the shorter term, however after the set period the loan will revert to principal and interest payments. Once that happens, your repayments will be significantly higher, and it may take you longer to pay off your home loan.
Let’s now look at the differences between fixed and variable rate home loans.
Home loans come with a fixed interest rate or a variable interest rate, and you are free to choose which one suits you.
If you opt for a fixed rate home loan, your interest rate is locked in for a defined period of time, typically anywhere from 1 to 10 years. This is called the term of your loan, and the interest rate will remain the same throughout the term.
If you opt for a variable rate home loan, the interest can change—go up or down—over time. This is usually based on the RBA's cash rate, which lenders use as a guide for the rates they charge you, their customer.
There is also another type of home loan, called a split loan, which has a portion of the loan which is variable and a portion which has fixed interest.
Let’s now look at each type of home loan in more detail.
A fixed rate home loan is exactly what it says on the tin: during the term of your loan—whether it's 1, 2, 5 or 10 years—the interest rate is fixed, which means your loan repayments stay the same every month.
When the term of the loan ends, the rate reverts to a variable interest rate, though you are free to negotiate another fixed rate term. You can also shop around and move to a new lender who may be offering a better deal.
In terms of features like offsets and the ability to make extra repayments, fixed rate home loans tend to offer fewer options than a variable rate.
Example: Using the same figures as above, if you had a home loan with an interest rate of 2.33% p.a. you would be paying $2,211 every month for the full term of the loan.
If you choose a variable rate home loan, your regular repayments can go up or down depending on interest rate changes. This gives you less certainty than a fixed rate loan, but variable rate loans do come with more features and flexibility. Typical features include the option for extra repayments, a redraw facility or an offset account, where your savings help to reduce the interest you pay.
Example: a fluctuating interest rate can make a substantial difference to the monthly repayments of a $500,000 home loan over a 25-year loan term:
Like any financial product, each option has its unique upsides and downsides to consider.
Take the time to consider the pros and cons of each interest rate option before you sign up for a home loan. As we have seen from the calculations in the examples above, a small difference in the rate can add up to a lot over time.
The most obvious benefits of a fixed rate home loan are:
On the downside, the cons you need to be aware of include:
The most obvious benefits of a variable rate home loan are:
On the downside, the cons you need to be aware of include:
Let’s now look at some other common questions around fixed and variable rate mortgages.
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