How to choose between a fixed or variable home loan

Choosing between a fixed or variable rate home loan is a common dilemma for many borrowers.

With interest rates at historical lows you may now be considering fixing in your home loan rate. But this may come with a catch.

We look at what they are and outline some of the key advantages and disadvantages of both to help you decide which option is suitable for you.

Differences between fixed and variable home loans

What is a fixed rate home loan?

A fixed interest rate home loan is a home loan with the option to lock in (or ‘fix’) your interest rate for a set period of time (usually between one and five years). One of the main advantages of this is cash-flow certainty. By knowing exactly what your repayments will be, you’ll be able to plan ahead and budget for the future. This factor often makes fixed rate home loans very popular for investors over the first 2-3 years that they own a property for.

Another reason why a fixed rate may be a good option for you is that any short term interest rate rises won’t affect the amount of interest you will have to pay. However, if interest rates drop, you might be paying more in interest than someone who has a variable rate home loan.

It’s also important to note that often additional loan repayments are not allowed with fixed-rate loans (or only allowed if you pay a fee). Because of this, the ability to redraw is also frequently not offered on a fixed rate loan, effectively reducing the flexibility of the loan.

This is a key factor to consider right now. With the dramatic fall in variable interest rates over the past few years, many people are in a great position to maintain repayments higher than needed and are paying off their home loan faster. Locking in a fixed rate may take away your ability to do this.

Related post: Why is home loan refinancing on the rise?

What is a variable rate home loan?

A variable rate home loan is a home loan where your interest rate will move (or ‘vary’) with changes to the market. This means your interest rate can rise or fall over the term of your loan.

Variable home loans also have appealing features like the ability to make extra repayments (often at no extra cost) to help you pay off your loan sooner and save you interest. Another advantage can include unlimited redraws (where you ‘draw’ back out the extra repayments you made).

Variable rate loans are more uncertain than fixed interest rate loans. This can make budgeting for your interest payments more difficult because you have to take into account potential rate rises. If you aren’t prepared, you could have trouble keeping up with repayments.

At the moment, with variable rates so low, they remain the most popular option due to the bonus of flexibility and unlimited redraw available on most loans.

Can I split my loan?

A popular home loan option is to split your loan between fixed and variable. This allows you to lock in a fixed interest rate for up to 5 years on a portion of your loan, while the remainder is on a variable rate. Effectively, this can help you ‘hedge your bets’ on an interest rate rise or cut, minimising the risks associated with interest rate movements.

At the end of the fixed rate period, you may have the choice of fixing that portion again (at the current market rate for fixed interest) or simply letting it revert to a variable interest rate. Keep in mind that the variable rate it reverts to may be higher than the variable rate you’re already paying on the other portion of the loan.

Fixing a home loan rate: Things to consider

While having a fixed interest rate can be attractive to those who value stability and are averse to risk (namely, the risk of rising interest rates), choosing to take out a fixed rate can actually be a bit of a gamble, ironically.

Fixed-rate mortgages have a number of potential traps, so there are a few things you should consider before applying for one:

1. Could interest rates fall?

If you’re tempted by some pretty low fixed home loan interest rates, keep in mind that they may be low for a reason. A 2-year fixed-rate of 2.29% p.a. may look pretty good now, but it may not look so good in six months’ time where there may be variable rates on offer for 2.00% p.a. or less.

When lenders think there’s a strong chance interest rates will fall in the near future, many try to tempt borrowers into taking out fixed rates, because that way there’s fewer customers for them to pass on future rate cuts to. So essentially, fixing your rate is like making a bet with your lender over whether market interest rates are going up or down. If rates rise, you win by avoiding a rate hike. If rates fall, you miss out on a rate cut, so the lender wins.

But the lender may have the better odds of winning the bet, because the smarty-pants analysts and economists in their loan pricing teams will have all the fancy graphs and data at their disposal to help them accurately forecast the market and set fixed rates accordingly.

2. Break fees

Really ask yourself whether you’ll be able to commit to the entirety of the fixed term. Because should you take out a fixed loan then later decide to refinance to a variable rate because you’re sick of paying a fixed rate that’s much higher than the low variable rates that all your mates are enjoying, you’ll be slapped with a break fee, which can amount to thousands of dollars. This also applies if you want to pay off the loan before the end of the fixed period, such as if you decided to sell your house.

3. Revert rates

At the end of the fixed-rate period, don’t expect the lender to automatically switch your loan to one of its lowest variable rates. Chances are your loan will revert to the lender’s standard variable rate, which can be over 200 basis points higher than some of its lowest rates. You’ll then probably want to refinance to a lower rate – a process which comes at a cost.

So what is the best option for you?

That is for you to decide – based on your own circumstances. The good news is that there are professional lending specialists that can guide you on options and help you make the right decision.

Variable rates have historically always been the preferred choice for most Australians due to their flexibility. But we’re in unprecedented times – so obtaining guidance is crucial.

Outside of the traditional big 4 Australian banks there are now so many more choices to help you obtain a loan approval – with a loan that is right for you!

Compare & save on home loans

If you’d like to know more about home loans in general, or would like a free review of your options, our lending specialists are available for a chat in person, online, or via phone.

Simply complete your contact details below and one of our lending specialists will be in touch.

This article is prepared based on general information. It does not take into account individual financial objectives or needs and is not financial product advice.