When applying for or refinancing a home loan an important consideration is whether to go with a fixed or variable rate. The common question is ‘what do you recommend’ but the answer lies within the borrowers’ own needs and circumstances to determine what’s appropriate to their situation.
Fixed Rates give you certainty for the fixed term. Variable rates may be lower than the fixed rates at the time of settlement, but can fluctuate over the life of the loan. We have seen this recently with the Reserve Bank of Australia (RBA) making several increases to the cash rate, which has resulted in most lenders increasing their variable rates to follow suit. Below is a brief summary of the pros, cons and considerations of each options.
Variable Interest Rate
Pros
Extra Repayment Flexibility: Variable rate loans give you the flexibility of paying off your home loan faster without incurring any break costs.
Features: Variable rate loans also give you the opportunity to have features such as an offset account and/or redraw facilities which help reduce the loan balance which you pay interest on. You may be asking yourself, what is an offset account/ redraw facility?
Offset Account: an offset account is an everyday bank account that’s linked to your variable home loan. The funds in this account will ‘offset’ the total amount that interest is charged on. For example, say you have a $500,000 loan with an interest rate of 3% you will be charged $15,000 ($500,000 x 3%) in interest for the year. If you have $50,000 in an offset account, you will be charged $13,500 (($500,000 – $50,000) x 3%) in interest which is a saving of $1,500 p.a.
Redraw Facility: similar to an offset account, a redraw facility will save you in annual interest charged. However, a redraw facility differs as it isn’t a separate bank account but rather a facility attached to your home loan. If you make additional repayments on your home loan above the minimum required, you will be able to access these via the redraw facility.
Easier to refinance: If you find a better deal elsewhere, it may be easier to switch to a different lender or home loan product if you’re on a variable rate, without attracting break costs.
You will benefit if rates fall: As we saw during COVID when rates were significantly decreasing, individuals with home loans on variable rates would’ve benefited as their repayments decreased due to the reduction in interest rates.
Cons
You will be disadvantaged if rates rise: As we’ve seen recently with the RBA increasing the cash rate due to inflation concerns, individuals with home loans on variable rates would’ve been disadvantaged. This is because their repayments increased due to the increase in interest rates. When applying for 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: 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 may not 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.
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.
Cons
Less flexibility: Fixed rate loans may limit a borrower’s ability to pay off their loan faster by restricting additional repayments or capping them at a certain amount a year.
Break cost fees: 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.
Fewer features: Features such as offset accounts and redraw facility that come with a variable rate home loan often aren’t available for fixed rate loan holders. Some lenders do offer these features with fixed loans, but the majority don’t.
Rate cuts may not 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.
Determining what’s right for you
The above information is good in theory, but when it comes down to determining what’s appropriate for your individual situation there are several considerations to consider. Below is a series of scenarios that will help you consider what might be right for you*: *The below amounts are all used for illustrative purposes and have no direct relation to the current interest rate environment*
When a variable loan may be appropriate:
A borrower is looking to purchase an investment property with the goal of selling in the foreseeable future. A 100% variable loan would be appropriate for this investor as they have the flexibility to sell their property whenever they please without the fear of paying extremely high break costs which are associated with a fixed loan.
When a fixed loan may be appropriate:
A property investor has purchased an investment property and isn’t looking to pay off their loan faster as the interest is tax-deductible. At the time of applying, the 2-year fixed rate on investment loans is 5% and on that interest rate, the rent received from the tenants is greater than the estimated repayment (positively geared). Therefore, this property investor is happy to lock in the fixed 2-year rate as he is protected from any increases to interest rates. Over the next 2 years, they can guarantee that the rent received will cover the repayments so they will have peace of mind knowing this. They are also not interested in an offset account as they have one linked to their owner-occupied loan where the interest paid isn’t tax-deductible.
A young family has purchased their first owner occupied property with a final loan amount of $500,000 and they have concerns that rates are going to increase, and they won’t be able to afford their repayments. The young family have met with their mortgage broker and determined that their comfortable monthly repayment for the new loan is $2,500 per month (without having to make any drastic changes to their everyday spending). A specific lender is offering a 2-year fixed rate at 4% p.a. which on a loan of $500,000 would result in an approximate repayment of $2,387 per month. Whilst the current variable rate may be cheaper at the time of the application, the young family have decided to lock in the 2-year fixed rate to give them certainty in their repayments for 2 years whilst they find their feet as first homeowners. Their monthly repayment of $2,387 is below their comfortable monthly repayment of $2,500 per month and they are protected from potential increases to interest rates in that 2-year period.
When a split loan may be appropriate:
A split loan can be very beneficial to most as you’re essentially protected either way. Let’s assume a borrower purchases a property and has a loan amount of $500,000. After discussions with their mortgage broker, they’ve determined that their comfortable monthly repayment is around $4,000. This particular borrower would like a 50/50% split loan, so they have a portion of certainty thanks to the fixed loan whilst also taking advantage of the cheap variable rate now and securing the access to an offset account. As this borrower has a strong borrowing power, throughout the first year they have accumulated $20,000 in their offset account. As they have taken advantage of an offset account, they have saved $20,000 in interest for that year. To show this, if their current variable interest rate is 3%, they will save approximately $600 in annual interest ($20,000 x 3%)
In summary, everyone’s personal situation is different, and a fixed/ variable product is purely dependent on that. As a mortgage broker I can help you navigate these discussions and determine what’s appropriate for you. If you would like more information to discuss, please reach please contact myself on 0401 225 713 or lmckean@lbkprivatelending.com.au.