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How do variable rate mortgages work?
Many Australian home loan deals offer variable interest rates. But how exactly do these variable rate home loans work, and what are the benefits and drawbacks compared to other mortgage options?
What is an interest rate?
When you apply for a home loan, you agree to pay the lender back the mortgage principal you borrowed to buy the property, plus an extra interest charge. The interest charged on each mortgage repayment is calculated based on the remaining outstanding mortgage principal, and the lender’s interest rate.
The interest rate a lender charges can make a big difference to the overall cost of the loan – home loans with low interest rates generally cost less than home loans with high rates. Banks and mortgage lenders tend to reserve their low rate home loans for borrowers who can fulfil specific eligibility criteria, such as having higher incomes, lower expenses, and paying larger deposits.
What is a variable interest rate?
Many lenders charge interest at a variable rate, which may rise or fall multiple times over a home loan’s lifetime (often 20 to 30 years).
Variable interest rates are often affected by the national cash rate, set by the Reserve Bank of Australia (RBA). When the RBA raises or lowers the cash rate, lenders often pass on this change by raising or lowering variable interest rates accordingly. Of course, lenders may also choose to move their variable interest rates out of cycle from the RBA based on other economic factors, such as changes to the cost of overseas funding.
When your variable rate goes up, your home loan repayments increase, which could put extra pressure on your household budget. But when variable rates fall, you may have a few options to consider:
- You could make cheaper repayments, relieving some pressure on your household budget, or;
- You could keep making the same repayments and have more of this money go towards paying off your mortgage principal. This could bring you closer to exiting your loan early and paying less total interest.
How does a variable rate compare to a fixed rate?
You may have the option to fix your interest rate for a limited time, often between 12 months and 5 years. During this time, your interest rate will remain the same, regardless of whether your lender raises or lowers its variable rates. Once this fixed rate term expires, your loan will revert to a variable interest rate – you may have to watch out for bill shock and mortgage stress if variable rates have been rising.
Keeping your repayments stable like this can be valuable for borrowers wanting to keep their household budget consistent. However, while fixing your interest rate may help to protect your budget from runaway interest rate rises, you may also miss out on interest savings if variable rates were to fall.
Also, fixed rate home loans are less likely to offer flexible home loan features, such as unlimited extra repayments, a redraw facility or an offset account. And refinancing a home loan during the fixed term could involve paying break fees, which can be expensive.
How do variable interest rates compare to split rates?
Another potential alternative to a variable rate home loan is a split rate mortgage, where interest is charged on part of your mortgage principal at a fixed rate and on the remainder at a variable rate.
A split loan may be able to offer you some of the potential benefits of both fixed and variable interest rates. If variable rates rise, your repayments won’t increase by quite as much, and if rates fall, you could still enjoy some interest savings. Plus, you may be able to access some flexible home loan features.
Of course, you can still only fix the rate on part of your loan for a limited time, after which it will revert to a variable rate. Keep in mind that this may not be the same variable rate as what you’re paying on the second part of your mortgage – you could find yourself with a loan split between two different variable rates!
Disclaimer
This article is over two years old, last updated on May 26, 2022. While RateCity makes best efforts to update every important article regularly, the information in this piece may not be as relevant as it once was. Alternatively, please consider checking recent home loans articles.
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