If you’ve found yourself scratching your head trying to figure out all the different types of interest rates and how they affect your mortgage repayments, you’re not alone. With debates about whether you should go for a fixed or variable interest rate, and terms like split rate thrown in, it’s almost easier to just agree with whatever your lender tells you to take. However, knowing the difference between each interest rate type could mean saving thousands of dollars over the life of your loan.
Whether you’re new to the property world, looking to buy your first home or are interested in refinancing, read on to find out:
- The benefits of knowing the ins and outs of rate types
- Why timing is important when it comes to choosing a fixed rate
- The pros and cons of choosing a variable interest rate
- What a split rate is and how it offers you the best of both (interest) worlds
- What to consider when choosing a rate type
In the frenzy of buying their first home, people often overlook the terms and conditions of their home loan – for instance that their interest rate changes after the first year of their loan. Lenders attract buyers with low offers, highlighting how you might save in the first year. But did you know that without calculating the amount you pay in interest over time and comparing it to other interest rates on offer, you could be missing out?
Couple this with certain features offered when you choose a select interest rate type and the amount of interest you pay could prove staggering in the long run. Not only could you accidentally prolong your loan term but you could also be paying more than you should be.
Here’s a breakdown of the differences between each rate and product type, and the benefits or drawbacks of each:
What is a fixed rate?
A fixed rate is when the interest rate you pay for a certain period of time becomes set (fixed) at the initial rate you and your lender agreed on. This period usually lasts for a few years meaning that if market conditions or the Reserve Bank’s cash rate change, the interest you pay on your home loan will stay constant.
This means that you will always know how much of your repayment is going towards paying for the principal amount of your home loan, and how much is going towards interest. While this protects you from sudden interest rate hikes, it also means you can’t take advantage of interest rate drops.
On a fixed rate, your lender may also charge you for making extra repayments, or prevent you from using features like an offset account. Most lenders offer a lower fixed rate for the initial period of your loan, usually for one to two years before switching back to a variable interest rate. To make the most of a fixed interest rate, if possible opt to lock in an interest rate when the rate is at its lowest and is about to improve.
What is a variable rate?
On a variable interest rate loan, you’ll be paying varying amounts of interest throughout your loan term. The interest rate fluctuates depending on various factors and the decision your lender decides to make. While the rate you pay isn’t determined by market conditions explicitly, most lenders follow current conditions, meaning that if the Reserve Bank of Australia lowers the cash rate, your interest rate will most likely go down too.
This means that while you still make the same repayment amounts every month, the amount that goes towards interest and the amount that goes towards paying off your actual home differs every time the interest rate changes. The main benefit to this is that in a down market you could be saving thousands in interest every year as the interest rate continues to collectively drop.
However, the flipside to this is that the interest rate could also drastically increase so much so that more of your repayment goes towards interest rather than principal. Since there is more risk that your interest rate will change, your lender is more likely to offer you offset or redraw features, or even the ability to make extra repayments at no cost. Depending on your income and how much free cash flow you have each month, this could be beneficial to your situation.
What is a split rate?
On a split loan, you’ll be able to reap both the benefits that those on a fixed and variable rate get. This is because essentially, on a split rate loan, you’ll be paying a fixed rate on a portion of your loan, and a variable rate on the rest of it.
While this means you’ll be subject to both the pros and cons of each rate type, you’ll also be getting the best of both worlds: assurance that your repayments will definitely be going towards your home loan, and the ability to use the banking features that variable loans offer.
As beneficial as it seems, it is still something that should be carefully considered. Choosing to opt for a split rate could mean that you pay more interest on the variable part of your loan, or if the interest rate lowers drastically, more on the fixed interest portion of your loan.
If you’re still interested in having your mortgage on a split interest rate, make sure to ask your lender whether or not you’re able to add the split rate feature to your home loan product. It is also important to keep in mind that there’s no definitive rule for splitting your home loan meaning that you choose which way to split your loan and which portion you wish to keep fixed and variable.
Where to from here?
Choosing the right interest rate type for you depends on your current situation, where you plan to be in the future and the property cycle. If your financial position has changed or improved, if your property has gained equity or you’re just looking for a better interest rate, making the switch could mean the difference between spending thousands of dollars, or saving it.
Similarly, if you’re looking to save for down the track, pay off your home loan as fast as possible, knowing how much you’ll be spending down the track based on any of your options could be beneficial. Lastly, it’s always important to know where the property cycle and market is currently at. If the market has begun to slow down and interest rates seem like they’ll continue to fall, it may be best to wait a little longer before locking in a fixed rate or refinancing to change your current rate type. Similarly, if the housing market is in a boom phase it might be beneficial to lock in a fixed or split rate as soon as possible to reap the benefits of a lower interest rate for a few more years.
Spend some time evaluating your needs and the options available to you, or better yet book a consultation here so we can guide you through the process!
Disclaimer: The information provided is general in nature and does not constitute financial advice. Please speak to us for recommendations on your individual circumstance and requirements.