For many Australians, a home loan is the biggest financial commitment they'll ever make and, with so many options available, choosing the right one can feel daunting.
One of the most important considerations is whether to go with a fixed or variable interest rate on your home loan.
Macquarie Bank’s Head of Banking Products, Drew Hall, says borrowers should consider their own needs and circumstances when deciding on the right rate mix.
“Fixed rates give you certainty for the fixed term. Variable rates can be lower than fixed at the time of settlement, but may fluctuate over the life of the loan.”
“Some borrowers might benefit from fixing part of their loan and have the remainder on a variable rate, that way if you’re in the fortunate position of being able to pay your loan off sooner, you can do so without incurring interest rate break costs.”
The majority of borrowers go with a standard variable rate home loan, but that doesn’t mean it’s the best option for everyone. Here are the pros, cons and considerations of each.
Variable interest rate: pros
Repayment flexibility: Variable rate loans allow for a wider range of repayment options, including the ability to pay off your loan faster without incurring interest rate break costs. Some variable rate loans also offer features like offset accounts or redraw facilities that work to reduce the loan balance you pay interest on, while still allowing you to access surplus funds.
Easier to refinance: If you find a better deal elsewhere, it’s easier to switch to a different lender or home loan product if you’re on a variable rate, without attracting break costs.
You stand to pay less if rates fall: Lenders may cut rates for a variety of reasons, mainly in response to reduced funding costs. If you’re on a variable rate, this means you’ll reap the benefits of lower repayments.
Variable interest rate: cons
You stand to pay more if rates rise: Lenders can change a variable interest rate at any time. For borrowers, this means their rate is likely to fluctuate over the life of their loan. If your bank raises rates, your repayments will also rise.
“The RBA’s cash rate is just one of the factors that drive funding costs for banks”, says Hall.
“Funding costs are also influenced by other factors, such as the rate at which banks lend to one another, the credit spread demanded by a bank’s wholesale investors and competition on deposit pricing. Prices may also be influenced by changes to capital requirements or significant cost changes.”
“It’s a complex mix of variables and a change in any of these components may cause banks to adjust their lending rates in either direction.”
“When you’re deciding on a home loan, it’s important to build in a buffer so you don’t face mortgage stress if variable rates rise.”
Cash flow uncertainty: Because rates can change at any time, it won’t be as easy for borrowers with a variable rate to predict cash flow over the long term. This inevitably means a variable loan requires more flexibility from the borrower. Making use of loan features including offsets and redraw facilities can help smooth out cash flow concerns, should unexpected events arise.
Fixed interest rate: pros
Rate rises won’t impact you: If you expect interest rates to rise over the next 1 to 5 years, locking in a fixed rate today could save you money on repayments in the future. When you approach a lender for a good deal on fixed rates, it’s important to note that the rate you apply for might not be the rate you get when you settle on the loan. Some lenders will guarantee a certain fixed rate before settlement but a “rate lock fee” may apply.
Set and forget: Locking in a fixed interest rate means your repayments stay the same throughout the loan period (typically between 1 to 5 years). Knowing your loan repayments will make it easier to budget and manage your cash flow – giving you more peace of mind.
Fixed interest rate: cons
Less flexibility: Fixed rate loans limit a borrower’s ability to pay off their loan faster by restricting additional repayments or capping them at a certain amount a year. Significant break fees can apply if you want to refinance, sell your property or pay off your loan in full before the fixed term has ended.
“Break costs are incurred because banks have to hedge the fixed rate payment”, says Hall.
“Break costs are normally higher when interest rates fall, because banks stand to lose money on the difference that they have hedged.”
Fewer features: Many of the desirable features that come with a variable rate home loan, aren’t available for fixed rate loan holders. Typically borrowers won’t be able to redraw funds over the fixed period or link an offset account to their loan.
Rate cuts won’t impact you: If you’ve signed up for a fixed rate, you won’t benefit from any cuts your lender makes to their home loan rates over the fixed term.
Split rate home loans
One way to hedge your bets on interest rates is by splitting your home loan rate. Many lenders offer the option to divide your home loan into multiple accounts so you can take advantage of both fixed and variable rates.
Allocating a percentage of your loan to a fixed rate might give you more peace of mind that when variable rates fluctuate, you can still afford monthly payments. At the same time, keeping a proportion of your loan variable gives you the flexibility to benefit from offset or redraw capabilities on that portion of your loan and take advantage of falling rates, if they come up.
Macquarie Bank home loan specialist Richard McHutchison recommends Macquarie’s offset home loan package for borrowers looking to split their rate.
“As long as $20,000 is allocated to a variable rate account, borrowers can divide the rest of their home loan into an unlimited number of loan accounts and take advantage of a mix of rate types.
“One of the benefits of Macquarie’s offset package is that you can link up to 10 offset accounts to each variable loan account.”
“You might want an offset to save for your overseas holiday, or one for school fees. All of your offset accounts work together to reduce the variable rate loan balance you pay interest on, saving you money on interest repayments.”
The rate you choose to go with may differ depending on the purpose of the loan.
Fixed rate loans can appeal to property investors who aren’t looking to pay off their loan faster and value the simplicity and predictability of fixed repayments.
First home buyers, with less equity in their home, might prefer a split rate home loan so they can get the best of both options. Borrowers looking to refinance, renovate or sell their property might decide on a variable rate so they can remain flexible when the time comes to make a move.
If you do decide to go with a fixed rate for all or part of your loan, Hall says it’s important to read the fine print on the type of variable rate your loan reverts to at the end of the fixed term.
“Some lenders revert to a standard variable rate, which can be significantly higher than the introductory variable rate they offer to new customers.”
“In the event that property markets fall or credit conditions tighten, it’s not always easy to refinance to a better rate, or a different lender, at the end of a fixed term. It pays to be cautious of introductory rates. If it sounds too good to be true, it probably is.”
A home loan is a long term commitment and your personal circumstances are likely to change throughout the course of paying it off. It’s important to revisit the rate you pay at various points to ensure you’re getting a good deal and using your loan features or rate splits effectively.
With Macquarie’s offset package, borrowers can adjust their loan splits by adding a new fixed rate account without incurring extra costs, says McHutchison.
“The offset package allows borrowers one free variation a year. If there’s a good deal on fixed rates, it might make sense for some borrowers to allocate a proportion of their variable funds to a new fixed rate account.”
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