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Choosing between a fixed & variable loan

by Jeremy Cabral

For people on a predictable income who know that they can’t afford much of an increase in interest rates in the near future, a fixed interest home loan allows them to lock in their regular repayment amount for up to five years.

The downside is a lack of flexibility to deal with the challenges that life often throws up.

Being on a fixed interest loan when you need to sell, renovate or make extra repayments can be troublesome and more expensive.

Whenever there are low rates on the market, it’s worth considering whether a fixed home loan will suit your needs.

What is a fixed home loan?

A fixed home loan is a rate of interest charged on the loan amount which doesn’t change for the duration of the fixed term, commonly between one to five years.

For example, a three year fixed interest loan with an interest rate of 6% p.a. will remain at 6% p.a. for three years.

At the end of the fixed interest period the loan will revert to a variable interest product from the lender. Borrowers can also choose to jump straight into another fixed interest period.

What is a variable home loan?

A variable home loan is a rate of interest that can rise or fall. Changes in the interest rate are at the discretion of a lender and are meant to be broadly in line with market conditions.

Answering the below questions will help guide a decision to fix or go variable.

Will you want to refinance if interest rates change?

Variable interest home loans are the product of choice for refinancers. They commonly have lower fees on entry and exit than fixed interest home loans. For borrowers who want to stay in touch with the best deals on the market, variable home loans are usually easiest to switch from.

According to the ABS, roughly 80% of borrowers are on variable interest rates*. Breaking a fixed interest home loan can be an expensive exercise. There may be break fees and early repayment adjustments that can add up to thousands of dollars.

Below is a basic example of the way technical total break costs are calculated for a borrower who has decided to repay their loan on the final year of a five year fixed home loan:

As you can see, breaking a loan only a year early can cost tens of thousands of dollars, and this cost could have been borne from something as innocent as the need to refinance to fund a renovation. In that case, the borrower has just lost the funds equivalent to a nice new kitchen in the process of breaking their fixed term.

Can I refinance?

Many first home buyers who’ve used Lenders Mortgage Insurance (LMI) don’t realise that if they refinance, they may need to pay LMI again if their Loan-to-Value ratio (LTR) is still above 80%.

In this situation, a fixed interest loan could be an option. A fixed interest loan can be used until such time as it is calculated that the LVR should dip below 80%. This might be a number of years later.

For example, let’s say Jen and Mark buy their first home for $400,000 using a $50,000 deposit. On a 25 year home loan at 6% p.a., it will take just under five and a half years to pay off enough loan principal to bring the LVR under 80% (ignoring the effects of capital growth) which would allow them to refinance without having to pay LMI again.

Many home loan calculators have an ‘amortisation schedule’, which shows the monthly projection of the loan particulars including the remaining principal.

Do you want a compromise?

If you’re still caught in two-minds between a fixed and variable interest home loan, it may be worth considering a split loan. Also known as a split rate loan, this is a loan which allows a portion of the repayments to be fixed interest, and another portion of the repayments to be variable interest.

While there are still some of the negative elements of a fixed interest loan, such as break costs (albeit, on a lower portion of the loan), it does allow for a mixture of security and flexibility.

Flexible features such as redraw, offset accounts, lines of credit and extra repayments still could apply (depending on the particular conditions of the loan) on the variable portion of the loan.

How long do you expect to hold the property for?

How long you expect to have a property for is a key consideration, because this will likely determine whether you are willing to fix your interest, and if so, for what length of time.

As explained earlier, the cost to exit a fixed home loan may be steep. Therefore, if the intention is to sell or buy (and if the latter is by using some of the equity in the property) in the short term, using a fixed interest home loan should be avoided. And if this is the case for the medium term, then a fixed interest loan of one year should be the maximum length.

For people unconstrained by a near-term buying future, they could take advantage of some of the low fixed rates on offer at the moment.

Do you need to renovate?

Variable loans are better for renovating — whether it be a standard variable loan with a line of credit option or a construction loan, variable interest allows the most flexibility to either take on additional credit to pay for labour and materials, or switch to a loan product that does offer additional credit facilities.

Borrowers need to put themselves in the mindset of whether they’ll require any funding from their lender within the hypothetical years that they could fix their interest for. If so, fixing probably isn’t a good option.

Do you need flexible features?

Many borrowers are more than happy with their basic, no frills, home loans. However, features such as 100% offset accounts and lines of credit are only available with variable loans and they can be more than handy.

100% Offset accounts, for one, work as everyday bank accounts linked to a home loan where the balance of the account is deducted from the remaining principal before interest is calculated. This can save borrowers thousands in interest over the life of the loan.

Lines of credit, for another, allow for ready access to large amounts of credit for a relatively low rate of interest. These funds can be used to buy a car, purchase investments or perform renovations.

Are you going to want to make additional repayments?

Your ability to pay off your loan early and reduce interest is limited on a fixed interest loan. In fact, not many fixed loans even allow extra repayments, and those that do tend to have modest limits.

Tips when choosing a fixed interest loan

  •  Look for finance that allows extra repayments and redraws.
  • Try to think realistically about the type of change that could occur in the short and medium term in your financial and family situation.
  • Get an idea of the types of costs you’ll be up for if you need to break the loan.
  • Choose a fixed term based on your needs and not just on the lowest rates offered between one, two, three and five year loans.

*Australian Bureau of Statistics, Housing Finance, February 2013

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