The beginning of the new financial year is a good time to review interest rates on existing loans, or if you are considering applying for a new loan. Here are a few terms and things to know about Fixed interest and Variable interest rates, to give some background to help you make an informed decision.
A Fixed interest rate is fixed at the interest rate for a period of time. Generally, fixed rates give you certainty for the fixed term;
A Variable interest rate fluctuates depending on what happens with economic and financial markets. Variable rates can be lower than fixed rates at the time of drawing down a loan, but may fluctuate over the life of the loan;
Interest rates are determined by the banks’ overall funding costs which are influenced by a number of factors, including:
The Reserve Bank of Australia (RBA) standing cash rate
Where funding is obtained by the bank – some have a high level of term deposits and savings accounts from their customers;
Some banks lend money from other banks. So, the interest rate at which banks lend to one another;
The margin required by a bank’s wholesale investors who provide funding (this can include large superannuation funds and large institutional investors);
Regulatory changes made to capital requirements, which may mean that the bank cannot lend out as much money; and
Competition, which we have seen in investor loan markets in more recent times, as the Australian Prudential Regulation Authority (APRA) has limited the amount of some types of loans that banks can offer (such as Interest Only and Investor loans).
Break Costs are:
the difference in interest rates between your current fixed interest rate and the new loan interest rate, to be paid so you can refinance;
incurred because banks incur a cost to hedge their risk against the fixed rate payment from their interest rate costs; and
normally higher when interest rates fall, because banks stand to lose money on the difference that they have hedged
When you apply for a Fixed rate loan, the interest rate that applies is the rate published at the time of your settlement. There is a risk that the interest rate will increase between your application and the settlement date. You can apply for a Rate Lock to protect against this happening.
A Rate Lock is where you pay a fee to guarantee your Fixed interest rate stays the same from the time that you make an application through to the date that the bank provides you with the funds (at settlement or draw down of your loan).
Most borrowers in Australia opt for variable rate Home Loans.
Below is a table of issues to consider when weighing up Fixed rates versus Variable rates.
Consideration Variable Fixed
Can I make extra repayments? Variable rate loans allow for a wider range of repayment options, including the ability to pay off your loan faster without incurring interest rate break costs. Fixed rate loans limit a borrower’s ability to pay off their loan faster by restricting additional repayments or capping them at a certain amount each year.
Are there Break Costs? Usually Break Costs don’t apply. This doesn’t mean that there are no fees such as discharge fees or government mortgage registration, but the bank won’t charge additional Break Costs for paying out a loan early. Significant Break Costs can apply if you want to refinance, sell your property or pay off your loan in full before the Fixed rate term has ended.
Can I have an Offset Account or a Redraw facility? Most Variable rate loans also offer features like Offset Accounts or Redraw facilities that work to reduce the loan balance you pay interest on, while still allowing you to access surplus funds. Many of the desirable features that come with a Variable rate home loan, aren’t available for Fixed rate loan holders. Typically borrowers won’t be able to redraw funds over the fixed period or link an Offset Account to their loan.
Can you refinance to another lender? If you find a better deal elsewhere, it’s easier to switch to a different lender or home loan product if you’re on a Variable rate, without attracting Break Costs. You can refinance to another lender, but you have to weigh up the financial cost of any Break Costs, versus the savings that you may make.
What happens when Interest Rates fall? You stand to pay less if rates fall: Lenders may cut rates for a variety of reasons, mainly in response to reduced funding costs. If you’re on a Variable rate, this means you’ll reap the benefits of lower repayments. 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 rate term.
What happens when Interest Rates rise? Lenders can change a Variable interest rate at any time. For borrowers, this means their rate is likely to fluctuate over the life of their loan. If your bank raises rates, your repayments will also rise. When you’re deciding on a home loan, it’s important to build in a buffer so you don’t face mortgage stress if Variable rates rise.” 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.
How certain are repayments? Because interest rates can change at any time, 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 rate loan requires more flexibility from the borrower. Making use of loan features including Offset Accounts and Redraw facilities can help smooth out cash flow concerns, should unexpected events arise. Locking in a Fixed interest rate means your repayments stay the same throughout the Fixed rate loan period (typically between 1 to 5 years). Knowing your loan repayments won’t change will make it easier to budget and manage your cash flow – giving you more peace of mind.
Which is better for Tax? Variable loans allow for additional repayments to be made. So, any debt that is home owner debt (so not for investment or business purpose) is usually what we recommend to be paid off first. So, a Variable loan in this instance assists to pay off debt that is not tax deductible. Fixed rates are usually better for investors. They lock in an interest rate on interest only terms. Then, concentrate on any additional funds available to pay off home loan debt which isn’t tax deductible.
Can you pay the interest In Advance? Interest cannot be paid In Advance on a variable loan. As a Fixed rate is already pre-determined and contracted, a borrower can elect to pay the interest In Advance for a year. This can assist a client to bring forward the tax deduction into the current financial year.
Some borrowers might benefit from Fixing the interest rate on part of their loan and have the remainder on a Variable rate, that way if you’re in the fortunate position of being able to pay your Variable rate loan off sooner, you can do so without incurring interest rate Break Costs.This is called a Split Loan.
A split loan can help in a number of ways:
For a first home owner who has a large loan, it could be split for say 50% or 60% to be on a Fixed rate loan, with the balance on a Variable rate loan. This would allow them to pay more off the Variable rate loan without penalty, and provide some certainty for a period of time on repayments.
For someone with a second home or moving or construction, this can give a mix of the benefits of the Fixed rates, and also to allow the Variable component to help with savings.
For an investor, this can be useful where the deposit component for an investment property purchase is funded as a Fixed rate loan and then the Home Loan component is Variable.
Deciding whether to Fix your interest rate or stay as Variable is a decision to be carefully considered. For more information, please contact us and we can assist to tailor your repayments to your specific requirements.