First home buyers, as part of the loan application process, are asked ‘fixed or variable rate?’ The choice is simply this: will your mortgage interest rate shift slightly as the Reserve Bank adjusts its official cash rate? Or will you pay a fixed interest rate for a defined period, usually two, three or five years?
No one can give you a definitive answer on the question of fixed versus variable: it’s one you have to decide for yourself. People typically take fixed rate loans for two reasons: they are property investors and they want to be certain of their interest costs over a defined period so they can write a budget; or, they’re a household and have taken the view that rates are at a low point in the interest rate cycle and likely to rise in future.
Some households on a tight budget may also be tempted to fix their rate to reduce the risk on stretching their budget with a variable rate rise. The benefit of a variable rate loan is that whether the rate is rising or falling or flat, you are paying the market price for housing debt, in that particular time frame. Most owner-occupied mortgages in Australia are variable rate loans, making us unusual by world comparison. One reason for this is that people who take a variable rate loan might assume that they can find extra funds if the rates rise.
However, before making this assumption, prospective borrowers should use an online mortgage calculator and see what extra mortgage repayments they’ll be responsible for if their variable rate rises 1.5 or 2 per cent in a year. Most home loans have been ‘stress tested’ by the lender to ensure there is enough household income to cover a rate rise, but you should also understand the impact of an interest rate rise yourself. Fixed rates have the attraction of certainty, but if you fix your rate at 5.5 per cent, and then the variable rate drops to 4.8 per cent, you are now paying more than the market rate, for as long as your loan term. Also, fixed rate loans often don’t allow accelerated pay-down strategies such as extra repayments and lump sums. Fixed rate loans also have a ‘break fee’ to leave the loan early.
For people who don’t see a clear case for either type of loan, consider this: if a lender offers a 3-year fixed rate loan at the same interest rate as their variable rate loan, then the lender is assuming the variable rate will be going down. If in doubt, remember that most lenders will allow you to ‘split’ your loan between fixed and variable. This gives you the certainty of one and the market-best rate of the other. Very few people accurately predict where interest rates will be in two or three years. In the end you must go with the loan that suits your circumstances.