When you are ready to purchase a property and apply for a home loan, invariably you’ll need to make a decision on whether you want a fixed or variable interest rate for your home loan. In this post, I will explain what the differences between the two are and how you can decide what is best for you and your circumstances.
Variable Interest rates
A Variable interest rate is what most borrowers take up and what it means is that your interest rate is subject to change. There may be multiple reasons why your interest rate may change including but not limited to RBA monetary policy where the reserve bank decides to use interest rates to control inflation as an example, the banks profit margins, the cost to raise funds in the market etc.
When one of these factors comes into play, the interest rate on your home loan may change for the better or for worse. As an example, let’s suppose you took out a home loan with a variable interest rate of 2.50% in August. Two months later, the reserve bank decides to increase interest rates by 0.25% and banks start finding it harder to raise funds at the same time. Your bank decides to increase interest rates by 0.30% as a result, to factor in the reserve bank increase and increased cost to raise funds so your interest rate by November is 2.80%.
Fixed Interest rates
Let’s look at what it means to ‘Fix your interest rate’. Essentially this is an option provided to you by the bank to ensure that your interest rate will not change for a specified period of time.
For example, if you fixed your interest rates for 3 years at 2.50% then your interest rate will remain at 2.50% regardless of what happens – to use the earlier example, if the RBA decided to increase rates by 0.25% and cost of funding went up, your interest rate would still be 2.50%.
On the other hand, if the RBA had reduced rates by 0.25% and your bank reduced variable rates by 0.25% – you would still have to pay 2.50% and wouldn’t get a rate reduction.
Break Costs on Fixed rate loans
The other thing to be mindful of with Fixed interest rates is Break costs. When you decide to take out a fixed interest rate, the bank also enters into a money market contract to ensure that the cost of their funding will also not fluctuate. There is however one key consideration with this arrangement and that is essentially a cost if one party decided to break this arrangement.
What this means is that if you decide to take out a fixed interest rate for a period of time and decide to change to a variable rate before that period is over, then you may need to pay some break costs which can be quite substantial. As an example, if you took out a fixed interest rate for three years at 2.10% and want to switch over to a variable rate because interest rates are 1.90% after one two years, you will have to pay some break costs which the bank will pass onto you for breaking the contract.
When do Break costs apply?
Break costs generally apply if you want to get out of your fixed rates and interest rates have generally gone down. If interest rates have gone up, then typically you do not have to pay break costs at all.
To explain this concept a little more, when you enter into a fixed rate loan then on the other side of your loan is an investor who is expecting a fixed return for the period of your fixed rate. A good way to think about it is that if interest rates reduce, then that investor is making a good return relative to the market as the decision to fix works out in their favour. However, if you want to break the fixed rate at that point, you will need to compensate that investor in the form of break costs as they will need to find a lower return investment after you break your contract.
On the other hand, if interest rates went up, the investor wants you to break as they can get a better return than what they are getting with your fixed rate and will not charge you anything if you wanted to break your contract. However, in this instance you will probably not want to break your loan (and this is the risk the investor takes).
So Break costs apply when you want to pay off your loan before your fixed rate term is over. However, they also apply if you wanted to pay some of your loan off during the fixed rate term and not the whole lot. For example, suppose you have a loan for $200,000 and fixed it for 3 years. After 1 year, you wanted to pay off $50,000 because you got a nice bonus and a pay rise. In this instance, you may need to break costs as well due to the same reason as before.
The good news here is that most banks provide some leeway (in bank speak, this is known as a fixed rate threshold). What this means is that the bank will not charge you for prepaying that loan up to that threshold. Most major banks in Australia have a threshold of $30,000 so if you wanted to make additional payments of up to $30,000 during the fixed rate period, you would not be charged a break cost.
The only other major consideration with Fixed interest rates is that you generally can not have an offset account with a fixed rate home loan. Stay tuned for my next post, where I will explain what offset accounts are.
What is best – Fixed or variable interest rates?
This is a difficult question to answer as it really depends on what your plans are for the home loan and what you think the Australian economy will do in the coming years. Interest rates are generally correlated to factors such as inflation and economic growth. If you think that the Australian economy will grow, inflation will increase and job growth will be positive then it may be best to take out a fixed interest rate as that would be a sign that interest rates will go up. However if you think economic activity will slow, inflation and jab growth will reduce, then maybe hand on to a Variable rate.
The other thing to consider are your plans for the home loan. If you think you are going to be paying off the home loan sooner or plan to sell the property in the short term, then variable may be the way to go.
Best of both worlds?
Another thing you may consider is to partially take out a fixed rate whilst keeping the other portion on a variable rate. For example, if you have a $500,000 home loan, you may decide to take out a fixed interest rate for $250,000 whilst leaving the other $250,000 on a variable rate. This would mean that the interest rate on half your loan will not change for the fixed rate period whilst it may for the other half. However if you wanted to make additional repayments or take out an offset account, you could do so with the variable interest portion of your loan.
How much you fix or leave as variable doesn’t need to be 50/50 – you could adjust this with your view on the future. If you think growth will be strong and interest rates are more likely to go up then you may decide to take out a fixed rate on 70% of the loan and leave only 30% as variable, it’s really up to you.
To summarise, Variable interest rates are subject to change whilst fixed interest rates do not change for the fixed period. You may have to pay break costs on fixed rates if you decide to pay the loan off early and generally cannot take out an offset account. It may be a good idea to hedge your bets if you’re not sure and fix a part of your overall loan.