Should I Chose A Fixed or Varible Interest Rate?
Help! There are so many decisions to make when choosing a home loan that it is easy to feel overwhelmed. An important decision to consider is whether the loan interest rate should be a fixed or variable one. It is also easy to fall into the trap of thinking, “How can I beat the banks?”, “How can I lock in a lower rate when rates start to rise?” However, there are many more considerations to the fixed verses variable debate.
What is a Fixed Rate?
This is an interest rate which is fixed for a period of time, anywhere from 1 year to 5 years and possibly 10 years for some lenders.
What is a Variable Rate?
With a variable interest rate, the rate fluctuates over time. The Reserve Bank of Australia (RBA) will set the cash rate and from this lenders will generally set their interest rates above this rate. Until recently lenders moved in accordance with the RBA. However, over the last few years, lenders have begun to move independently of the RBA, in response to the changing credit markets.
Peace of Mind: The No. 1 Benefit of a Fixed Rate
The number one benefit of a fixed rate is peace of mind. If you chose to lock in your interest rate for 3 years (for example) you know exactly what you will be paying each month. It takes the anxiety of a possible rate increase out of the picture. I often think that this is an important consideration for someone who will not have a lot of free income once they have made their mortgage repayment. If you are on a tight budget and rates begin to rise it makes for some stressful times ahead unless you have fixed your interest rate.
Fixed Rates: The Loss of Flexibility
The down side of a fixed rate is that it has less flexibility than the variable option. If you pay extra into your home loan, then it can not be re-drawn. This means that if you were to pay an extra $1,000 (for example) into your home loan, then you can not take it out again should you need to. For some clients of mine, this is okay. They don’t make additional repayments. Often in families where there are small children, with the expense of day care and reduced income, they know that they are unlikely to pay extra into their home loan. This feature is not a significant inconvenience in this situation.
Fixed Rates: The Danger of Break Costs
The loss of flexibility also involves in the possibility of break costs. When a loan is fixed for a set period, the lender expects you to remain with them for that term. Should you decide to refinance to another lender, or sell your home, the lender will charge you a ‘break cost’ for leaving them. There is no fixed amount for this. The amount will fluctuate depending on the interest rate you fixed at, the variable interest rate at the time you break the loan agreement and the period of time you have left on your fixed term. The higher the rate you fix at, the lower the rate when you leave, and the longer you have left on your fixed term, the higher the break cost.
To put this into perspective, I once had a client who locked in at above 9% for 5 years. Two years into the fixed term, when interest rates had fallen significantly, he decided to sell his house. Due to the size of the loan and the time remaining in the fixed term, his break cost was close to $20,000!
Flexibility: The No. 1 Benefit of a Variable Rate
The flip side of this problem is that the flexibility of a variable rate is an important feature for some people. If you have a high disposable income and your financial goal is to pay off your home loan as quickly as possible, then a variable rate may be more suitable for you. It allows you to put as much extra into your home loan as you can, but also allows you to re-draw it as you wish. As interest is calculated daily on the amount that you owe, reducing the balance of your mortgage as quickly as possible can result in significant savings over 30 years.
No Hard and Fast Rules
Finally, there is no hard or fast rule with this debate. There are good arguments for both fixed and variable. As a mortgage broker I encourage my clients to consider their home loan from their own individual perspective. As always, the loan which is suitable for one client, may not be suitable for the next.