Fixed or variable?

Find the right type of interest rate for your home loan.

One of the many decisions you’ll have to make when applying for a home loan is whether to apply for a fixed or variable interest rate.

RACQ Financial Advocacy Analyst Nathanael Watts reveals the benefits and limitations of each option.

How is an interest rate determined?

The interest rate charged on a home loan is made up of a number of factors including:

  • How much it costs the bank to obtain the money to lend to you
  • The Reserve Bank of Australia (RBA) Cash Rate and other market interest rates
  • Overhead costs
  • Profit margins.*

What is a variable interest rate?

Mr Watts said variable interest rate loans are the most common type chosen by home buyers. As the name suggests, the interest rate can change over the course of the loan.

The interest rate charged is determined by the bank or lender and can be changed at any time.

An increase in your variable interest rate means your mortgage repayment will increase. A decrease in your variable interest rate means your mortgage repayment will decrease. However, the flexibility of a variable loan will mean you can continue to make additional repayments to pay off your loan sooner.  

Borrowers should allow for potential repayment increases in their household budgets.

What are the benefits of a variable interest rate?

Variable interest rate loans are generally more flexible than fixed interest rate loans.

Most variable loans allow you to make additional repayments (either unlimited or to a set amount) which reduces the time it takes to pay off your mortgage and limits the interest charged.

Many also come with a redraw option, which allows the borrower to withdraw any additional repayments they have made, or an offset account that uses your savings balance to reduce the monthly interest payable on your loan.

A variable interest rate loan is also more flexible when it comes to refinancing. Banks cannot charge an exit fee when a borrower chooses to refinance to another bank or lender but there may be other costs associated with refinancing including mortgage release fees, establishment fees for the new loan and government charges.

What is a fixed interest rate?

Fixed rate loans set the interest at the time the loan is funded and can’t be changed by the bank.

Typical fixed rate loan periods range from one to five years in length.

This means the borrower will know exactly what repayments are required during the fixed period of the loan.

What is the risk associated with a fixed interest rate?

Keep in mind that the interest rate applied to a fixed loan is determined at the time the loan funds are released. If the interest rate changes after you started discussing the loan with the bank you may receive the new interest rate when the loan is finalised.

This risk can be avoided by paying a ‘rate lock’ fee which ensures you will receive the interest rate originally agreed to. This can be particularly useful if you think interest rates may increase soon.

Once the loan is funded, you are locked in t the fixed variable rate.  If interest rates subsequently fall, your interest rate will still remain the same.

Fixed rate loans are less flexible than variable loans. During the fixed rate period, refinancing becomes more expensive as a break fee applies. This can mean that even if there are cheaper interest rates available elsewhere, you may not be better off refinancing after paying the break fee.

What is the benefit of a fixed interest rate?

When interest rates increase your repayments will remain unchanged, saving you money compared to variable rate loans.

You will also know exactly how much you need to repay each month for the duration of the fixed rate period.

In a low rate environment, you can also lock in a low interest rate for the fixed rate period

Can I make additional repayments on a fixed interest loan?

Most repayments are restricted to the standard minimum repayments, but some loans will allow a limited amount of additional repayments each year. This can limit the ability to repay your home loan faster and save on the interest charge.

Redraws and offset accounts are generally not available with fixed loans.

It is important to remember that the fixed interest rate period doesn’t last for the full life of the loan.

Once the fixed rate period ends, the loan will typically revert to the standard variable interest rate however you may have the option to refix the loan at the current interest rate.

Your bank should contact you prior to the fixed rate period ending to allow you to consider your options.

Can I split my loan into part fixed and part variable?

You can create a combination of variable and fixed rate loans, known as a split loan.

A split loan aims to utilise the best feature of both types of loans. 

You will need to determine how much of your loan you want to borrow at a fixed rate and how much at a variable rate. After you choose the length of your fixed rate portion, work out the maximum additional payments you’d be able to make in that period and use that as the amount in your variable rate loan. The remainder is the amount in your fixed rate loan.

For example: you need a $100,000 loan and choose to fix the loan for two years. You determine that the maximum additional repayments you could make in that period is $20,000. In this situation you may choose to make $25,000 the variable portion of your loan (a bit more than your $20,000 estimation of additional repayments to account for the minimum repayments that will be paying down the loan), which leaves $75,000 as the fixed portion.

You will have more repayment flexibility, compared to just a fixed rate loan, as you will be able to make additional repayments on the variable rate loan and be able to redraw funds if required.

Typically, you won’t be able to refinance the variable loan without also refinancing the fixed rate loan, which means the break fee will still apply on the fixed portion.

*Profits are treated differently in mutual banks compared to traditional shareholder banks. While shareholder banks use profits to pay dividends to their shareholders, profits made by mutuals are retained and reinvested for sustainability of the business and to improve their products for their members.

The information in this article has been prepared for general information purposes only and not as specific advice to any particular person. Any advice contained in the document is general advice and does not take into account any person's particular investment objectives, financial situation or needs. Before acting on anything based on this advice you should consider its appropriateness to you, having regard to your objectives, financial situations and needs.