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The fixed versus variable home loan debate

The fixed versus variable home loan debate

Choosing between variable, fixed and split rate home loans can feel like playing a game of rock, paper, scissors – all about predicting what’s likely to happen next.

With interest rates continuing to rise for owner-occupier and investor home loans, borrowers may be feeling uncertain as to which type of loan they should commit to. Choosing between variable and fixed interest rates can be difficult, but there are ways to get ahead.

What is a fixed home loan?

A fixed home loan allows you to lock in an interest rate on your mortgage for a length of time to enjoy greater stability and simpler budgeting in your personal finances. Most lenders will offer fixed periods between 1-5 years, however some do offer fixed home loans of up to 10 years.

Fixed interest rates give you certainty; if you can afford the repayments today, you can afford them next year (assuming your circumstances remain the same). It’s this peace of mind that appeals to many fixed rate borrowers because their repayments stay the same whether rates fall, rise or stay the same.

What is a variable home loan?

Fixed home loans can be frustrating if you lock in a rate before variable rates drop, because exiting a fixed-rate mortgage can be costly.  Most borrowers stick with the variable rate rollercoaster, which keeps things flexible – allowing for extra repayments, for instance.

A variable home loan usually starts with a lower home loan rate offered by the bank, which fluctuates depending on the cash rate determined by the Reserve Bank of Australia (RBA).

Is it worth the risk?

In recent weeks, dozens of lenders have increased interest rates for owner-occupied and investor home loans, including the big-four banks.

This has followed changes to regulations made by the Australian Prudential Regulation Authority (APRA), including limiting interest-only loans to 30% of all new loans supplied by banks and lenders. The RBA has responded to changes in regulations and rising interest rates by holding the cash rate at an historically low 1.5%.

A recent RateCity survey has shown that 1 in 10 people who have refinanced their home loan in the past two years switched from a variable to a fixed home loan with the same bank.

Borrowers’ best options

While interest rates can make a substantial difference to your repayments and the total interest you pay on your home loan, the past has proven it’s very hard to predict which option will perform better.

Fixing in October 2005 would have saved borrowers 15%, or around $12,200 compared to variable over the following three years. Fixing a home loan rate in September 1991 would have cost a borrower an extra 30%, or $29,800, over the next three years.

Typically, when the gap between fixed and variable rates widens due to either an increase in variable rates or a decrease in fixed or both, it could be the right time to fix.

Another good time would be if fixed rates were not much higher than the average basic variable rate. For example, if the average basic variable rate was 4.97%, and some lenders were offering three-year fixed loans at 5.1%, with a difference between the two of only 13 basis points, it could be worth fixing. 

However, most Aussies tend to ‘panic fix’ when rates are at the highest. For example, more than 25% of new loans were fixed in March 2008 when the RBA cash rate was at a peak at 7.25%. When rates fell to 3% a year later, only 4% of new loans were fixed. 

Ultimately, choosing between a fixed or variable rate is still a personal choice. It is important that you factor in whether you can afford at least a 2% rate increase no matter what type of loan you decide. 

Tips to consider before fixing

What are the break costs?

Lenders can charge borrowers fees when you make extra repayments on a fixed home loan. Most will allow you to pay a small extra amount off your mortgage without being charged. but if you go over this amount, or fully pay off your loan ahead of schedule, you may be charged break costs. As of July 2011, variable mortgages have no early repayment penalties or exit fees, however fixed rate break costs and discharge fees still apply.

Track your bank’s interest rates

If your loan’s fixed term is coming to completion, it is wise to monitor it well ahead of time and discuss your best options with your bank before it finishes. You may want to fix again or revert to a variable rate, depending on whether you believe rates will continue to rise or fall.

Consider taking out a split loan 

If you still can’t decide, perhaps a split loan is for you. Having half your loan in a variable account could allow for flexibility, while the other half of your loan remains secured at the fixed rate.

Pros / Cons of fixed rate

  • Protected against raising interest rates
  • Protected against cash rate fluctuations
  • Set an accurate budget
  • If lenders drop rates you’re stuck paying more
  • Less flexibility to make extra payments
  • Typically have expensive break fees
  • Loan may take longer to pay off, so you’ll pay more interest

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