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When it comes to choosing a home loan, one of the biggest decisions you’ll face is choosing between a variable or fixed rate home loan. Here, we explain why interest rates fluctuate, discuss the pros and cons of variable rate home loans, and share tips on how to reduce the amount of interest you pay.
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 your repayments will be less, but you’ll run the risk of paying more when they rise. 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.
Interest rates can fluctuate depending on a number of factors.
The most important factor is the Australian cash rate. On the first Tuesday of every month (except in January), the Reserve Bank of Australia (RBA) meet to set the cash rate. They decide whether to raise it, lower it or leave it the same, depending on a number of factors, including the performance of the Australian dollar, the state of the housing market and inflation.
This cash rate decision influences other interest rates throughout the country, including inflation, economic activity, and the behaviour of borrowers and lenders in the property market.
It’s important to note that mortgage lenders are free to change their interest rates independent of the RBA’s decision.
These days, more lenders are changing their interest rates without the RBA moving the cash rate. Recently, lenders cite their ‘cost of funding’ as the reason for the increase. This is because the banks sometimes get their funds from sources outside of Australia in order to lend to us, and these funds have different rate changes that may not be obvious to us.
So it is important to know, that the RBA doesn’t have to change the cash rate for your bank to increase or decrease the interest rate on your variable home loan.
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.
The main advantages of variable home loans include:
Fluctuation of the interest rate can result in lower monthly repayments
Can include multiple features such as a redraw facility or an offset account
Ability to make extra repayments
If you want to refinance there us no break fee as there usually is with a fixed term
If you choose a variable rate home loan you need to be financially prepared if rates do change, and don’t go your way. Disadvantages of variable home loans can include:
Repayment amounts can vary month to month
If interest rates go up, so will your repayments
It can become harder to manage household expenses
Higher risk of mortgage stress
Lenders can change their interest rates independent of RBA cash rate decisions
If a variable home loan isn’t for you, there are other options. These include fixed rate home loans and split rate home loans.
A fixed rate home loan is a type of loan that functions as a secure rate, so even as interest rates fluctuate, your interest rate, and therefore repayments, will remain the same. A rate is typically fixed for a set term, such as 2, 3 or 5 years. After the term is up, the rate reverts to a standard variable rate that is determined by your lender.
While you may benefit from the stability of a fixed rate, many fixed rate home loans have limited extra features. These can include restrictions on extra repayments, and depending on your lender you may not be eligible for a redraw facility or an offset account.
Related: Read our complete guide to fixed rate home loans.
A split rate home loan involves combining both types of home loans into one. This allows a home buyer to enjoy the benefits of both fixed and variable home loans. One portion of your loan will remain unchanged if interest rates rise, while the other portion will give you some breathing room should the rates decide to drop.
The fixed portion of the loan can help you budget by allowing you to determine what you will repay each month. The variable portion then allows you to take advantage of features generally only available to variable loans, like offset accounts and redraw. However, it is important to remember that you may also be charged additional account fees for both rates.
Related: Read our guide to split rate loans here.
The answer to this question will depend on your own personal situation and your financial goals. Variable rate home loans are by far the most popular option chosen in Australia, but that does not mean it’s right for your needs.
In today’s climate, variable rates are often favoured because of the low cash rate set by the Reserve Bank of Australia. However, lenders are free to raise their rates independent of the cash rate and they have recently exercised this freedom by increasing interest rates for investment loans in particular.
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 sometimes chosen by homeowners who foresee significant lifestyle changes ahead such as starting a family. As childcare costs climb, many new parents seek solace in their ability to accurately budget thanks to a stable repayment amount.
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 family, before making any decisions.
Still confused? Chat to a Lendi Home Loan Specialist for free expert advice.
It is possible to get an offset account if you have a variable rate home loan, in fact they are sometimes the only loan type that can have a 100% offset account. However, depending on the lender some split loans and fixed rate loans also have the possibility of an offset account.
Calculate how much you might save with an offset account in seconds.
In order to determine what type of loan is right for you, it’s best to look ahead and determine your future long term goals such as starting a family or buying another investment property. Home loans tend to have a lifespan of up to 30 years, so this is a decision that should not be taken lightly. If you want free advice specific to your situation, chat to a Home Loan Specialist today.
Related: Read our guide to offset accounts.
Related: Learn more about redraw facilities.
Switch your repayments to weekly or fortnightly: Home loan interest is calculated daily. You could save hundreds on interest each year by simply increasing the frequency of your repayments from monthly to fortnightly, or even weekly if your lender permits.
Offset your interest: By keeping cash, such as your salary, in an offset account rather than a savings account you can automatically reduce the total amount you are paying in interest each month. This can save you thousands over the life of the loan.
Split your risk: If you are concerned about future rate rises, consider locking in part of your home loan with a fixed rate and leaving the remainder at a variable rate. This way you could benefit from the best of both worlds.
Purge expensive debt: Consolidating your higher interest debt like credit cards, car loans and personal loans into your home loan can help reduce your overall repayments.
Compare IO vs P&I rates: Since June 2017, principal and interest (P&I) rates have been considerably lower than interest only (IO) rates across the board. If you can afford to switch to a P&I loan, you’ll be paying less in interest and more towards owning your home outright sooner.
Shop around for competitive interest rates: Always get the best deal by comparing lenders. Use an online home loan platform that has all the major banks and other lenders in one place. We can help you do this here.