Variable or fixed interest rate, which should you choose?
There are plenty of decisions to make when applying for a home loan. Which lender should you choose? How much should you borrow? Should I use a mortgage broker or go straight to my bank? Actually, this last one is a rhetorical question. If you're just accepting whatever your bank offers you, then you're crazy!!!
But the decision that causes many of us to question ourselves is, "should I/we fix our interest rate or not?". It's like we have the fixed interest rate fairy on one shoulder, and the variable interest rate fairy on the other, and they're both arguing their cases right into their respective earholes. Sounds like fun...not!
So, I'm going to break down each option for you so you know what's good and bad about each, and what questions you should be asking yourself to nail down which option to go for.
VARIABLE INTEREST RATES
If your home loan has a variable interest rate, it means the bank can change that rate at any time. They may increase your rate, which means your regular repayments will increase, or they will decrease your rate, meaning your repayments will go down.
If you had to take a guess at which way banks tend to move interest rates for existing clients, which would you go with? I think we both know the answer to that one.
So, why would you choose a variable interest rate? Well, there are plenty of reasons...
- At the time of securing your loan, variable interest rates may be better than fixed interest rates.
- You may be of the opinion interest rates are likely to go down at the next rate change.
- You can pay as much into your loan as you want, in addition to the minimum repayments.
- You can take as much of those additional repayments out whenever you want if the loan product has a redraw facility. Some lenders will charge a fee and have minimum redraw amounts, but the opportunity is there.
- Often there is a choice to have a full offset account linked to the home loan account. An offset account is the same as an ordinary transaction account, but it helps to reduce the amount of interest you pay on your home loan. For example, if you owe $400,000 on your home loan, and you have $50,000 in your offset account, you only pay interest on $350,000. That can save you a lot of money in the long run. Some banks offer partial offset accounts, and while they do have some affect on your interest repayments, in my opinion they are generally a waste of time.
- You can refinance to another lender at any time without being charged high break fees. I have heard of some lenders waiving break fees, or not having any at all, but this is rare and you should check before fixing your rates.
Variable interest rates give you a lot of freedom, and loads of opportunities to save money. But, if interest rates go up, this might cause some stress if you are working to a tight budget. No one can see into the future, and you can never tell what the banks will do.
FIXED INTEREST RATES
If your home loan has a fixed interest rate, it means that no matter what the lender does with their interest rates, your rate will stay the same during the fixed interest period. And while there are plenty of reasons to choose a variable interest rate, there are a few reasons to choose a fixed rate instead...
- Fixed rates may be better than variable rates when you apply for your loan.
- You may want the security of knowing exactly what your minimum periodical repayments will be. If you're trying to stick to a budget, this can come in very handy.
- You can choose the fixed rate period, usually anywhere from 1-5 years, but sometimes up to 10 years. At the end of the fixed rate period your loan will transfer to a variable rate, or you can possibly fix the rate for another block of time.
Sounds great, right? Not so fast...
- Interest rates might go down, and you'll be stuck in a higher rate.
- Usually, there is a cap to how much extra you can pay into the loan above the minimum repayments. These can be quite restrictive with some lenders, while others are very generous.
- Chances are you won't be able to redraw any of the extra funds you've repaid if you need it.
- If you want to refinance your loan during the fixed rate period, there are likely to be break costs involved. These are usually very high.
WHAT SHOULD YOU DO?
Historically speaking, borrowers have paid less in repayments on variable interest rates than fixed interest rates. But, we live in strange financial times, and past performance doesn't necessarily indicate what the future will look like. Before making a decision about fixing your interest rate or not, ask yourself these questions:
- Are fixed or variable interest rates better right now?
- How likely are you to want to pay extra into your loan? Does a fixed interest rate allow you to make the kind of additional repayments that fit your budget?
- Do you want to have access to those additional repayments?
- Do you want the freedom of being able to change lenders without significant break costs?
- Are you the kind of person that wants to know exactly what your repayments will be for the foreseeable future, or are you happy if they fluctuate over time?
Notice how I didn't include, "what do you think interest rates will do in the future?" That's because no one has a crystal ball, so it's pointless trying to predict what banks and the world's finance markets are going to do. Stick to what you can control when it comes to the decisions you make.
If you still can't decide, you do have the option split the loan between variable and fixed interest rates. You can apply variable interest rates to a portion of the loan, and a fixed interest rate to the rest. For example, you could split the loan 50:50, or 60:40, or 80:20...or whatever ratio suits you best. The choice is yours. This allows you to take some advantage of rate changes no matter which way they go, make extra repayments into the variable split of the loan, and redraw those extra payments as you please. Having a bet each way on the interest rate has its benefits.
One thing to remember about interest rates is that they aren't guaranteed on settlement day. The interest rates that were available when you applied for the loan may have changed by the time your loan settles. The interest rates at the time of settlement are what will be applied to your loan amount.
You can lock in the rate you are quoted when you apply for a loan, but rate locking usually comes with a fee. Talk to your mortgage broker about whether this is the right thing for you to do. Every lender has different fees, and your broker might be able to lock in the rate without paying a fee.
Whatever you decide to do, make sure you choose a loan product that has the features you need, flexibility that suits your comfort levels, and fees that suit your circumstances. And go and see a mortgage broker or two before making a final decision. It's always better to have multiple options and expert advice before making what is likely to be the biggest financial decision of your life.