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Should I choose a variable or fixed interest rate home loan?

A man in a suit holds a variable rate circle in one hand and a fixed interest circle in the other, and questions which home loan he should opt for. Source: Yahoo Finance

It’s the age-old and hotly contested question: should I fix my home loan rate, or take the risk (and possibly reap the rewards) with a variable rate?

Both fixed interest rate and variable rate home loans have their pros and cons, but you definitely need to do your research before you pick either one.

So, what’s the deal with fixed rate home loans?

The interest rate charged on a fixed rate home loan is determined by the banks (which are influenced by market forces), not the official cash rate, which means your interest doesn’t go down if the RBA slashes the official cash rate.

Independent Mortgage Planners managing director, Craig Morgan, has some strong opinions on fixed rates, and it’s not the fixed rates themselves that are the issue, it’s the way they’re being sold to Aussies.

“Australians only fix rates, as a general rule, when the fixed rate is lower than the prevailing variable rate,” Morgan said.

But, what Aussies don’t know, is that when we’re seeing fixed rates lower than the prevailing variable rate, it’s telling us one thing: “All the economists that work for the bank are pretty certain that all rates are going to go down and stay down for a reasonable period of time.”

What does that mean?

Well, people who jump into a fixed rate that’s around 0.1 per cent or 0.2 per cent under the prevailing variable rate will end up paying around 0.3 to 0.4 per cent over, because a low fixed rate means economists are predicting a drop in the near future.

On top of that, most fixed rate mortgages only allow you to make up to $10,000 additional repayments on your loan, so you’re capped even if you’d like to pay it off earlier.

Are fixed rate home loans actually a good option?

Morgan said there is one reason (and one reason only) to choose fixed rates: you need certainty of repayment.

This means they’re a great option if you’re an investor or a young couple preparing for the future.

“Investors want certainty of repayment because they want to match their rental income to their mortgage outgoing or vice versa, and want to know, "What is that gap? What do I have to cover?’,” Morgan said.

And, if one half of a couple is planning to take some off or move from full-time to part-time employment pending the birth of a child, a fixed rate will give them certainty of repayments.

“In other words, they've done their budgets saying, "We can afford our current mortgage; but we think we'd be stretched if it went up much’,” he said.

Take a look at the major banks’ current fixed and variable interest rates for home loans

Currently, ANZ is offering the most competitive three-year fixed rate as 3.84 per cent per annum, CBA offers 3.84 per cent, NAB offers 3.89 per cent and Westpac is the most expensive at 3.99 per cent.

The fixed interest rates for the big four banks as compared to their standard variable rates. Source: CBA, ANZ, Westpac, NAB.

What would my monthly repayments for a $400,000 loan look like for a fixed and variable rate over 30 years?

The monthly repayments of a $400,000 (over 30 years) home loan with variable rate loans and fixed loans. Source: Finder

I need certainty of repayments. How long should I fix my loan for?

Morgan said lenders have traditionally competed most aggressively around the three-year term, which means that’s where rates tend to be shaved the most, but he’s seen it happen in the two-year term as well.

But, it’s really a matter of matching the term of the fixed rate to the period that you need certainty for.

If you need certainty for five years, but three-year rates look more attractive, Morgan said it’s not as simple as just opting for a three-year term and renewing your loan for a two-year term after that.

“If things have gone the wrong direction, at the end of three years the two-year rate is going to look nothing like what it looks like now. It's going to be much higher, of course,” he said.

His advice?

“Get clear your goals and objectives first, then worry about the structure and features of your home loan.”

What about variable rate home loans?

Variable rate home loans typically offer more flexibility than a fixed rate loan, but borrowers are subject to changing interest rates.

Mortgage Choice’s chief executive officer, Susan Mitchell, said interest rates on variable rate mortgages are determined by lenders, and in part by the official cash rate set by the RBA.

So, if the RBA drops rate, your home loan rate could reduce, but on the flip side, if it increases, so could your rate.

You can also make as many extra loan repayments on your variable rate home loan as you like, and you access a redraw facility or offset account to repay your loan quicker.

While you can benefit from drops in rates, Mitchell said the potential downside of a variable rate home loan is that, if you’re not disciplined with your budget, and you don’t prepare for rate rises, you could face financial hardship.

But, Morgan said it’s “absolutely reasonable” to say that if you look back over any fixed rate period, even if you’ve experienced volatility, variable repayments would “almost certainly” have worked out to be less than fixed rate repayments.

“In other words, variable rates would have worked out cheaper over time, generally not by a whole lot, but the simple fact is if you're going to select fixed rates, do so for the right reason: certainty of repayment,” he said.

What could happen to variable rate home loans if the RBA slashes rates on Tuesday?

Mitchell said should the RBA cut the official cash rate, she expects to see at least some of that rate reduction passed on to borrowers

But, if recent history is anything to go by, the last time the RBA cut the rate, few lenders passed the full rate adjustment on to borrowers.

“That being said, some lenders are already reducing their variable rates, in anticipation of a drop in the official rate,” she said.

Here’s how much you could save on a $400,000 variable rate home loan (over 30 years) if the RBA cuts rates:

The annual and monthly savings on a $400,000 variable rate home loan (over 30 years) if the RBA cuts rates by 0.25 per cent. Source: Finder

Here’s that compared to two and three cuts, which Westpac has predicted to occur this year:

The annual and monthly savings on a $400,000 loan (over 30 years) should the RBA cut rates two and three times (by 0.25 per cent each time). Source: Finder

I’ve fixed my loan, but the RBA cut rates. What can I do?

If you’re thinking it’s as easy as “can’t I just swap between the two?”, think again.

When you switch between a fixed and a variable, you need to pay a “break cost”, which works out to be the cost of the difference between the fixed and the variable rate anyway.

“So all of that benefit you think you're gaining by going onto the variable rate, it's already gone. You pay that to the bank straight away,” he said.

And, if that variable rate comes back up, it’s a double whammy on the borrower, because not only have they paid to jump down to the variable rate, they’ll now have an increased rate anyway.

His advice?

“If you’re locked into a fixed interest rate mortgage, be prepared to ride it out for the full term.”

But, fortunately for home-buyers, you don’t need to choose one or the other.

Mitchell says some borrowers decide to split their loan into a fixed and variable portion.

“By structuring your loan this way, you can allocate a proportion of your loan amount to a fixed interest rate, and a proportion to a variable interest rate,” she said. “You can decide how you split it, 50 fixed/50 variable, 20 fixed/80 variable.”

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