FIXED OR VARIABLE INTEREST RATE LOANS: WHICH WAY FORWARD
A home loan is one of the biggest financial decisions you will ever make. Before you commit you need to understand what type of loan would be best for you. There are a number of different types of loans available and the right one will depend on your current circumstances and your future goals. In this time of significant social and economic change, we ask the question, what are the current differences between fixed and variable loans and is one better than the other?
VARIABLE INTEREST RATE LOANS
These are loans where the interest rate charged on the outstanding balance changes as the market interest rates do. This means that your regular payments will vary (both principal and interest).
FIXED INTEREST RATE LOANS
These are loans that have the same fixed interest rate for the life of your loan regardless of what happens to market interest rates. This means your regular payments will stay the same for the duration of the loan.
WHAT IS THE BEST LOAN FOR YOU – FIXED OR VARIABLE
Research has shown that you are more likely to pay less interest overall with a variable interest rate loan compared to a fixed rate loan. However, it must be noted that past performance is not indicative of future performance. You must consider the amortization (spreading payments over multiple periods) of your loan. The longer this amortization period is, the bigger the impact a change in rates will have on your payments.
During the COVID-19 we are seeing a bigger difference between fixed and variable interest rates. In the past average fixed rates have been around 30 basis points lower than variable interest rates. In March and April 2020 this difference has increased to 84 basis points
To help stabilise the economy, lenders are looking to reduce bank funding costs and in turn are offering extremely low fixed rates.
As at May 2020, the average three-year fixed rate is 2.64 per cent, and the average variable rate is 3.48 per cent for owner-occupiers taking out principal-and-interest loans. A borrower with a $400,000 loan would pay $175 less per month, or $2100 per year, if they opted for a fixed rate loan over variable.
Given all of this, should you be going for a fixed interest home loan.
Typically, when there is a significant difference between fixed and variable interest rates, leaders are anticipating further cash rate cuts. As the cash rate lowers interest rates could drop further. If the variable rate decreases, those that are on fixed interest rates are left paying at their agreed fixed rate. It can often be very costly to break fixed term contracts should you want to move from a fixed to variable rate.
Five cuts in 12 months has put the cash rate at record lows.
Driven by affordable bank funding and record low interest rates, at this point, the decrease in variable interest rates is not as significant as fixed interest rates. But there are a few more things you need to look at before considering a fixed home loan. Fixed loans will give you set repayments and cash flow but are not as flexible as variable home loans. We never know what is around the corner in life and sometimes flexibility is what you may need. Fixed home loans may not include offset accounts or redraw facilities and they also have caps on extra repayments you may wish to make.
Lastly, remember that even though fixed rates are now very low there is still a chance that they could fall even further, so do you research before you lock your home loan in.