• Should you choose a fixed, variable or split loan?

    It’s the question a lot of Australians with a mortgage have to grapple with – should I choose a fixed, variable or split home loan?

  • It’s the question a lot of Australians with a mortgage have to grapple with – should I choose a fixed, variable or split home loan?

    What is a fixed rate loan?

    A fixed rate loan is a loan with an interest rate that stays the same over a set period of time. Homeowners with a fixed rate loan often find it easier to organise their budget than those with variable loans, as each month they pay the same amount in mortgage repayments.

    “Although most lenders allow some degree of additional repayments, your fixed rate loan is a bit like a big ice cube which reduces at a steady, predictable pace,” says John Tindall, principal of a Sydney-based financial advisory firm. “And that means you can budget for it.” 

    fixed-variable-split-house 
    Picture: realestate.com.au/buy

    Advantages of a fixed rate loan

    The main advantage of securing a fixed rate home loan is that you know exactly what your repayments will be over a given period. But there are other advantages, too.  

    • Makes it easier to stick to a budget – fixed interest rates mean fixed repayments, and that means you can work out your expenses more accurately during the length of your fixed term.
    • Set financial goals with confidence – by making it easier to stick to a budget, fixed rate loans enable you to plan for the future.
    • Rate rises won’t affect you – fixed rate home loans protect you from interest rate rises. It’s therefore worth considering a fixed rate loan when interest rates are low and more likely to increase during the length of your fixed term.  

    Disadvantages of a fixed rate loan

    The certainty afforded by a fixed rate loan is a double-edged sword. While it makes budgeting easier, it could also cost you money. Here are some disadvantages of a fixed rate home loan.   

    • Rate drops won’t apply to you – just as a fixed rate home loan protects you from unwanted rate hikes, it also prevents you from enjoying the benefits of a rate drop.
    • Harder to pay off your loan sooner – most fixed rate loans come with restrictions on additional repayments, which prolong the length of your mortgage and makes it harder to reduce your interest payments.
    • Less chance of a redraw facility – a redraw facility allows borrowers to access any repayments they have made on their loan that exceed the minimum required repayments. Most fixed rate loans do not offer a redraw facility.
    • Repayment fees – most fixed rate loans charge borrowers a break fee for paying off their loan early, ending the fixed term early, switching back to variable or re-fixing to get a lower rate.   

    fixed-variable-split-woman-ipad
    Picture: Pexels

    What is a variable rate loan?

    A variable rate loan is a loan with an interest rate that changes throughout the term of the loan, often in response to changes to the official cash rate or variations in banks’ funding costs.

    “They have been great for the last 30 years, as interest rates have been mostly declining since early 1989. But they can have a nasty bite when they’re going up,” says Tindall.

    Advantages of a variable rate loan

    Essentially the direct opposite of a fixed rate loan, a variable rate loan offers greater flexibility and a broader range of added features. 

    • Extra payments are allowed – most lenders allow unlimited extra repayments, usually at no extra cost. This means you can reduce your interest payments and pay off your loan sooner.
    • Features & facilities – variable loans generally come with a large suite of features, such as offset accounts and unlimited redraw facilities.
    • Benefit from rate drops – banks generally increase or decrease their rates in line with broader market movements. So, if the Reserve Bank of Australia decides to cut the official cash rate, you could be in the box seat to reduce your monthly interest payments.
    • Increased flexibility – lenders generally make it easier for borrowers to switch or alter the terms of their agreement if they have a variable rate home loan. 

    Disadvantages of a variable rate loan

    As with the fixed rate loan, whether you view a variable rate loan’s features as an advantage or disadvantage will largely depend on your personal financial situation and the state of the market.  

    • Makes budgeting more difficult – variable interest rates make it difficult to accurately calculate your monthly expenses. As a result, borrowers may find it harder to budget and plan for the future.
    • Vulnerable to rate hikes – as lenders are likely to change rates in line with broader market conditions, signing up for a variable rate loan means you run the risk of experiencing a sudden rate hike. Depending on the state of your finances when this happens, this could leave you in a state of mortgage stress.  

    What’s the major difference between a fixed rate and variable rate home loan?

    A fixed rate home loan is a home loan with an interest rate which remains unchanged for the duration of the fixed term – commonly between one to five years – whereas a variable rate home loan is a home loan with an interest rate that can rise or fall.

    Tindall says most people have a variable rate loan, either because they haven’t remortgaged for years, or because they thought that interest rates would drop over time.

    “And they’ve been mostly right for the past 30 years,” he says.

     fixed-variable-split-kitchen 
    Picture: realestate.com.au/buy

    What about split loans?

    A split home loan is a home loan that allows the borrower to nominate a proportion of their loan as fixed and a proportion as variable. Playing both sides of the fence like this allows borrowers to more accurately manage their home loan’s level of risk and security.

    For example, split loans with a larger fixed component afford borrowers more stability than a 100% variable rate loan, whilst still allowing them to make additional repayments so that they can pay off their loan sooner.

    And split loans with a larger variable component afford borrowers more flexibility than a 100% fixed rate loan, whilst minimising their exposure to sudden interest rate fluctuations, so that they can budget more accurately.

    “In my opinion, it’s mainly a considered choice between predictability and flexibility,” says Tindall.

    Case study

    Sarah and Peter borrow $440,000 to buy a $600,000 apartment.

    If they opt for a fixed rate home loan with an interest rate of 1.99% and a two-year term, they will pay $1,634 a month (including $10 monthly fees and based on a 30-year loan period).

    If they choose a variable rate loan at 3.5%, they will initially pay $1,976 a month, although their repayments will rise to $2,101 a month if the bank raises rates to 4%.

    Given Sarah and Peter plan to have a baby soon, they decide to fix 70% of their home loan for 2 years to reduce their exposure to potential interest rate hikes and make it easier to stick to their budget.

    Choosing a split loan rather than a fixed rate loan also allows them to make extra repayments when they can afford to do so.


    fixed-variable-split-laptop 
    Picture: Pexels

    So, what’s best?

    As with most financial matters, neither option is better than the other; which option is best for you depends on your personal situation and the state of the market.

    “If you’re concerned about the impact on your family budget, then consider a fixed rate loan,” says Tindall.

    “If you want to smash your loan down, consider a variable rate. If you want a bit of both, then split. And if you’re confused, ask your Home Loan Specialist.” 

     

    Originally published on realestate.com.au as ‘Should you choose a fixed, variable or split loan

     

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  • Disclaimer:

    While such material is published with permission, RAMS is not responsible for its accuracy or completeness.  This information is general in nature and has been prepared without taking your objectives, needs and overall financial situation into account. For this reason, you should consider the appropriateness of the information to your own circumstances and, if necessary, seek appropriate professional advice.