Is there any danger in taking out a variable rate loan?

Choosing between a fixed or a variable rate home loan is one of the major decisions borrowers will have to make in their mortgage journey. However, you may have heard friends or family mention the “dangers” of taking out a variable rate home loan. 

The risks of a variable rate home loan

A variable rate home loan is one in which the interest rate set by the lender may fluctuate according to market conditions, as well as the lender’s discretion. Alternatively, a fixed rate home loan is one in which the interest rate is locked in for a set period (typically 1-5 years), meaning your repayments will not change in that time. 

Taking out any home loan comes with a level of risks that borrowers should be aware of. So, what are the risks involved in taking out a variable rate home loan?

Interest rate fluctuations

When people discuss the dangers of taking out a variable rate home loan, they are typically referring to the risk of rate fluctuations. Over a 20-30 year home loan, it is inevitable that home loan rates may change.

A variable interest rate can change in response to changes in the official cash rate set by the Reserve Bank of Australia (RBA). Think of the cash rate as a benchmark rate for banks and lenders to set their interest rates against, including personal loans and savings accounts. 

When the RBA increases the cash rate, your lender will typically follow suit and lift your home loan interest rate accordingly. If interest rates rise, your monthly repayments could increase as well, potentially putting strain on your household budget.

For example, if the cash rate were to increase by 0.25%, your home loan rate should too. This can be the difference between paying a few hundred or thousand dollars more a year in interest charges, depending on your current rate and the size of your mortgage. 

If your interest rate is fixed, you are protected from any rate fluctuations throughout the fixed period. However, this doesn’t mean fixed rate customers never experience rising rates. Once the fixed period ends, borrowers will need to re-fix or refinance in a potentially higher-rate environment. 

Harder to manage your budget

The other ‘danger’ of taking out a variable rate loan is that fluctuating interest rates result in greater pressure on your household budget. It can be difficult to manage your budget and account for ongoing expenses when your lender is changing your mortgage rates, as this influences how much your mortgage repayments will be. 

For example, between May 2022 and June 2023, the RBA increased the cash rate an unprecedented twelve times . RateCity analysis shows that for the average borrower with a $500,000 loan before the hikes started in May 2022, would be paying a total of $1,134 more a month in interest by June 2023 - an increase of 49%. 

While this specific example was a more extreme cycle of tightening from the RBA, it goes to show that fluctuating interest rates can put pressure on everyday household budgets. To avoid falling into mortgage stress, it may be worth keeping your repayments below 30% of your income when you take out your mortgage. This may give you a better buffer in the event that rates rise. 

The benefits of a variable rate home loan

That being said, it’s worth keeping in mind that there are advantages to taking out a variable rate home loan over choosing a fixed rate option. 

More access to features

Variable rate home loans are generally more likely to come with helpful features, like an offset account or redraw facility. Lenders typically reserve loan features to variable rate home loan products. 

These features may help to reduce the interest charged on your mortgage, or chip away at your principal owing. While a variable rate home loan may fluctuate due to changes to the cash rate, you may be able to reduce your mortgage costs by utilising these features.

No break fees

If you decide you want to refinance your variable rate home loan, you may do so without paying a costly break fee. Break fees are charged by lenders to fixed rate home loan customers that want to leave their fixed period early. You will need to check with your existing lender as to how much this fee will be, as it is based on how much variable rates have changed since you first took out your loan.

Lower rates means lower repayments

The risk of rising interest rates can be intimidating for homeowners. However, if the RBA cuts the cash rate and your lender passes this on to your mortgage, you’ll also get a reduction in your mortgage repayments. This is the risk and potential reward involved in choosing a variable rate home loan. 

If you suspect the cash rate may fall soon, it may be worth considering a variable rate home loan. A cut to the cash rate could save you big in your ongoing repayments. Whereas fixed rate home loan customers miss out on any reductions to their mortgage repayments throughout the fixed period. 

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