Understanding the different ways you can pay interest is an important part of choosing the right home loan for your situation. Here we explain what a fixed interest rate loan is and how it can benefit you.
A fixed rate home loan means that a specific interest rate is ‘fixed’ to a home loan for a set period of time. No matter how the cash rate fluctuates over the fixed term, the borrower’s interest rate will not be affected. This means that their loan repayment amount will stay the same for each month over the fixed term period.
Fixed rates are generally set for a predefined period, popularly 2, 3 or 5 years. The rates offered over these terms have historically been lower than other fixed terms.
At the end of the fixed rate term, the loan will default to a variable rate unless the borrower chooses to enter another fixed rate period. Lenders have processes in place to advise customers of their options to renew their fixed term 4-6 weeks prior to the fixed term maturity.
Fixing a home loan interest rate can provide borrowers with a level of financial certainty and relief, among other things:
You’ll pay the same amount each month over the fixed term
Provides borrowers with stability and assurance
Protected against rising interest rates during the fixed term
Monthly budgeting is made easier
While fixed rates may provide borrowers with financial certainty, there are some drawbacks to consider. As the name suggests, they are less flexible than variable:
If interest rates drop you won’t benefit unless you refinance
Lenders may charge for breaking or overpaying (partially breaking) your fixed term loan.
Fixed rate loans provide fewer features and flexibility than variable rate loans
Most lenders do not allow 100% offset accounts
Typically cannot make unlimited extra repayments. Most lenders allow an additional $10,000 per year but this differs slightly lender to lender
Many lenders do not offer a redraw or construction facility on fixed rate loans
Break costs are fees charged by a lender when:
A borrower opts to either end a fixed term prior to its maturity
A borrower pays more than their maximum allowed amount in extra repayments on top of their minimum contracted amount
Break costs are charged because the lender will make a financial loss if a borrower breaks a fixed term loan. When a borrower breaks a fixed term the lender will then need to on-sell these funds at a potentially lower rate. The cost of on-selling plus the difference in rate typically results in a financial loss to the lender. They recoup this loss by calculating the amount lost and charging it to the borrower.
Learn more about increasing or decreasing your home loan repayments here.
Break costs are calculated based on the length of time remaining on the fixed term, and the difference in the lender’s cost of funds at the time of breaking in comparison to when the fixed term was initially taken. If the lender’s cost of funds has increased this could mean that there is no break cost.
A fixed rate home loan is not the only option when choosing how to repay your home loan. The two other ways to pay interest on your home loan include a variable rate home loan or a split rate home loan:
A variable rate home loan is a loan with an interest rate that can change at any time. This means that when interest rates are low you’ll pay less in your monthly repayments, but you’ll run the risk of paying more if it rises. Unlike a fixed rate home loan, the repayments for a variable rate loan fluctuate according to changing interest rates and may differ from month to month.
A split rate home loan involves paying a portion of your home loan at a fixed rate, and the remainder at a variable rate. This allows a property owner to enjoy the benefits of both a fixed and variable rate home loan. If interest rates rise, the pre-agreed portion of your home loan will remain unchanged, while the other portion will give you some breathing room should the rates decide to drop.
The fixed part of the loan helps you budget and allows you to determine what you will repay each month. Depending on the lender you choose, you may be able to make extra repayments and link an offset account to your home loan. However, it is important to remember that you may also be charged additional account fees for both rates.
Learn more about the pros and cons of split rate home loans.
There is no universal answer here, the right interest repayment type for you will depend on your specific circumstances and your financial goals.
Consider the market: Variable rates can be volatile, but in the current climate a lot of customers are leaning toward variable rates since they can benefit from the Reserve Bank of Australia’s low cash rate.
Consider your budget: Alternatively, fixed interest rates are generally considered a favourable option by borrowers who require a level of financial stability in their lives. Fixed rates are often chosen by homeowners who foresee a need for stability in their ongoing repayment.
Consider the future: At the same time it’s important to consider stability in the homeowner’s living situation. For instance, if a borrower plans to move house in the future they could be put into a position where they will need to pay an unpredictable amount toward a break cost. In hindsight, this could be viewed as an unnecessary risk.
If the prospect of fixing your interest rate feels too limiting, but you are still after stability, then you might consider a split loan. Split loans can provide borrowers with the best both worlds.
When choosing how to structure your home loan repayments it is important to consider your future plans, such as starting a family, before making any decisions.
Most lenders will only allow borrowers to have a partial offset account during their fixed rate period. However, there are some lenders who offer up to 100% offset with a fixed rate home loan. To find out if you can get an offset with your fixed rate loan, speak to a Lendi Home Loan Specialist for free expert advice.
If you want out of your fixed rate term, you typically have two pathways to consider:
Wait it out: Fixed rate home loans generally have a lifespan of 1-5 years. Once this term comes to an end, the loan will usually default to a variable rate loan. Your first option is to wait out the term set by your lender. Once it is over, the borrower is free to choose to either engage in another fixed rate term or repay their home loan at a variable rate. They can also choose to split the loan between fixed and variable rates.
Refinance: If you don’t want to wait, then switching your home loan might be an option to consider. It’s important to do your homework and make sure that it’s financially smart to switch, since you’re existing lender will likely charge a fee for breaking your fixed term. To work out if you’ll pay less each month by switching your home loan, chat to a Lendi Home Loan Specialist.