In this article:
Have you recently found yourself obsessing over homes? Are you thinking about taking the leap into the property market, but you’re somewhat overwhelmed by the amount of jargon and the effort involved? Don’t feel alone if you have started googling and after 20 minutes and 55 different pieces of financial jargon, you’re feeling a bit lost.
First of all, congratulations! You’ve taken the first steps on your journey to property ownership. Now’s the time to keep doing your research about mortgages, what’s involved in getting a home loan, and getting a grip on some of the basics you need to be aware of.
Comparison rate. Variable rate. Fixed interest rate. Redraw. Break costs. Revert. Offset accounts. The maze of financial jargon can take some getting used to.
Let’s look at a home loan 101 question to help you get started – what is the difference between a fixed, variable or split home loan?
It’s all about the interest
Fixed, variable and split home loans are all types of home loans or home loan products. The difference between them is how the bank, or lender, charges interest on your loan.
Interest is the amount of money a lender charges you to ‘use’ their money. It is determined by the bank and is a percentage of the amount you borrow. The interest is charged at each payment (let’s say, each month) and is calculated against the amount of the loan that remains at that time. This can be a big deal, as these fees will add up to hundreds of thousands of dollars over the course of the average Aussie home loan (25-30 years).
The interest charged is referred to as the loan’s ‘interest rate’ and each loan type (fixed, variable or split) determines the interest rate you will pay in a slightly different way.
As both your situation and the bank’s interest fees will change over time, it is important to consider which type of loan may best suit you. Read on for an overview of each type of loan and their key pros and cons.
What is a ‘fixed’ home loan?
A fixed home loan has a ‘fixed’ interest rate. This means that the lender (e.g. your bank) and the borrower (you) agree on an interest rate that will not change for a set period of time.
When this period of time ends (usually after 1-5 years) the lender will get back in touch with a new offer. As you renegotiate or ‘refinance’ you may agree to lock in a new fixed rate or switch to a variable rate.
Pros:
- They protect the borrower from interest hikes – you are protected from an interest rate increase during the fixed period. So, regardless of market changes, your interest rate remains fixed at a certain level. This can save you money if you’ve locked in a low interest rate at the start of the loan.
- You can be confident that the repayment amount for the loan will not change for the duration of the agreed fixed rate period, with no increase or extra repayments likely.
- Fixed rate loans tend to be budget-friendly – monthly payments are easy to budget for as they are always the same.
- The stability they offer can be good for long-term homeowners / owner-occupiers.
Cons:
- No benefit as rates drop – your home loan rates will not fall if interest rates drop during this period.
- Fees – you will likely pay a Lock Rate fee to set up a fixed interest rate, as well as pay other fees or penalties should you wish to make extra repayments or refinance during the fixed rate period.
- Can be inflexible – many fixed rate loans offer fewer loan features such as offset accounts or redraw facilities compared to other loan types and limit extra repayments during the fixed rate period.
- May be harder to qualify for when interest rates are high – repayment affordability can be difficult to demonstrate.
- Being locked in may not be as good for short-term homeowners
- Fixed rate will end – this loan will need to be renegotiated in an ongoing fashion which may not appeal to all borrowers.
Variable home loans
‘Variable’ rate home loans have no locked-in interest rates. The interest rate offered by the bank when the loan is taken out will change over time at the bank’s discretion.
Banks and lenders can change variable interest rates in response to a variety of factors, such as general market changes, the actions of competing banks / lenders, and, most likely, when the Reserve Bank of Australia (RBA) changes the cash rate.
Pros:
- Will take advantage of any drop in interest rates – meaning you will pay less interest on the home loan balance while interest rates are low.
- Can be more flexible about repayment types – with options such as switching to interest only repayments.
- More features are usually available – your loan may allow you to make extra repayments, have offset funds or redraw facility – allowing you the potential to pay off the loan faster, with less interest, or access repayments you’ve made if you need cash.
- Usually these loans are easier to refinance to a more competitive rate without break fees.
Cons:
- Interest rate increases will impact your repayments – rate hikes mean you can pay significantly more from month to month.
- Variability in repayments – with rates likely to change with little notice, it can be harder to budget due to market factors beyond your control.
- Fees – with extra features comes a potential for more fees. There will also be increased fees if you get behind with your repayments.
Split home loans
Split interest home loans do exactly what they say – they split the loan amount into multiple parts, each with different interest rates. The loan can be divided into different ratios (50-50, 40-60, 20-80) with part of the loan at a fixed interest rate and another portion of the loan at a variable rate. This type of loan increases certainty for the loan but also allows you the more flexible features of a variable loan.
Pros:
- Loan features – you typically have access to more loan features like offset accounts or redraw facility and additional repayments could be made on the variable portion of the loan to pay off your loan faster and with less interest in the long run.
- Interest rate changes are mitigated – a portion of the loan is protected from a significant rate increase in response to interest rate hikes but you can still benefit when the interest rate falls.
- Increased repayment stability – having a portion of the loan at a consistent fixed rate it is easier to determine affordability and budget for repayments.
- Flexibility in loan options – you can determine how to split the loan to suit your personal or investment needs.
Cons:
- Increasing interest rates – the interest on the variable portion of your loan will increase if banks increase their rates in response to any economic changes.
- Repayments can vary from month-to-month – as rates change, the interest on the variable portion of your loan will impact repayments. This can make budgeting harder.
- Fees – a variety of fees will apply due to the different features possible in a split loan situation. This will include Break fees on any fixed rate portion of the loan if you choose to refinance or repay the loan early.
- Less positive adjustment to interest rates – due to the fixed rate portion of your loan you will not fully benefit should interest rates drop below your agreed fixed rate.
How do you choose?
Of course, the loan that is right for you is going to depend on your needs and preferences. You will need to strongly consider your financial situation, your goals and your personal preferences.
It is important to consider the loan options available to you and seek the advice of mortgage professionals.
