What's the difference between variable and fixed rate home loans?

Borrowers taking out home loans have a choice to make when it comes to their interest rates – variable or fixed? There are advantages and disadvantages to both of these options, as well as to choosing a split rate mortgage. 

How does a variable rate home loan work?  

Many Australian home loans charge interest at a variable rate. In other words, the lender providing the mortgage may choose to change how much interest they charge on a home loan from one month to the next. 

If a lender raises its interest rates, borrowers can expect their next home loan repayment to cost more. But if a lender cuts their interest rate, a borrower could enjoy some budget relief from a smaller repayment, or keep making the same repayments and put the extra money towards paying off their property early. 

Lenders set their home loan interest rates based on a wide range of factors. One common example is the national cash rate set by the Reserve Bank of Australia (RBA) – when the cash rate rises or falls following each monthly RBA meeting, variable home loan rates tend to rise or fall accordingly. 

Of course, some banks also choose to raise or lower their interest rates out of cycle with the RBA, possibly in relation to other economic factors such as the cost of overseas funding. 

How does a fixed rate home loan work?

It may be possible for a borrower to fix their home loan interest rate, so their repayments will remain the same, regardless of whether the lender raises or lowers its variable rates. Lenders in Australia will let you fix your interest rate for a limited time, often between 12 months and 5 years. Once this fixed rate term expires, the loan will revert to a variable rate, though you may be offered the chance to re-fix your rate. 

One of the main reasons many borrowers choose fixed rates is that they keep their repayments stable and consistent for a limited time. This can make budgeting for your home loan repayments much simpler, as you won’t need to worry about your household costs going up if the RBA raises rates. Of course, you could also miss out on interest savings if your lender was to cut rates, as you’d still be paying the same fixed rate of interest. 

Fixed rate home loans aren’t always as flexible as variable rate home loans. They may not offer as many flexible features such as the option to make unlimited extra repayments, use a redraw facility to get these extra repayments back out of your mortgage, or to use an offset account to have your savings help reduce your mortgage interest. Also, you may not be able to refinance your mortgage and switch to another lender during the fixed rate term without paying break fees, which could be expensive. 

How does a split rate home loan work?

A third option for some borrowers to consider is a split home loan, where interest is charged on a percentage of your mortgage principal at a fixed rate, and on the remainder at a variable rate. This could potentially allow you to reap some of the benefits of both loan types, such as keeping your repayments from increasing too much when variable rates rise, enjoying some interest savings if variable rates fall, and enjoying some access to flexible repayment features. 

Keep in mind that just like other fixed home loans, the fixed rate on your split loan will eventually revert to a variable rate… and not necessarily the same variable rate as the second part of your loan. You could end up paying interest at two different variable rates! Of course, you could also consider re-fixing the loan or refinancing to a single rate. 

For example

Imagine that you had a $500,000 home loan with a 25 year term remaining, and are making monthly principal and interest repayments. By splitting your loan in half and putting a fixed rate of 3 per cent on the first half and a variable rate also of 3 per cent on the other, you’d be paying $1186 on each half per month, or $2372 per month together – so far, about the same as you would with a standard fixed or variable home loan at 3 per cent interest. . 

Now imagine that your lender raised its variable rates by 50 basis points to 3.5 per cent. You’d continue paying $1186 per month on the fixed half of your loan, but $1252 on the variable half, for a combined $2438. That’s still less than the $2503 per month you’d be paying if your whole loan was on a variable rate. 

Imagine that instead your lender cut its variable rate by 50 basis points to 2.5 per cent. You’d continue paying $1186 per month on the fixed half of your loan, but $1122 on the variable half, for a combined $2308. That’s a saving from the $2371 you’d still be paying if your whole loan was on a fixed rate, though not as much as you may save if you were on a variable rate and paying $2243 instead.

These calculations are estimates and this hypothetical example is for illustrative purposes only.

Which is the best interest rate option?

Much like choosing the best home loan, finding the best interest rate option may depend greatly upon your individual financial situation, requiring you to compare the available choices while considering how they may suit your goals. 

If you’re not certain whether a variable, fixed or split rate home loan may best suit your needs, you could consider contacting a mortgage broker for more advice.

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