Choosing the structure of your loan is one of the most significant decisions you’ll make as a borrower. However, structuring your loan can be a daunting task.
Typically, borrowers choose between two main options: a fixed rate loan or a variable rate loan.
Both options have their advantages and disadvantages, so you should choose the loan structure that is best suited to your financial situation and goals.
One of the most important factors to consider when picking a loan structure is the interest rate.
The cash rate is Australia’s official interest rate and is set by the Reserve Bank of Australia (RBA). Currently, Australia’s cash rate is 0.10%, which is a historic low.
Graph of the Cash Rate Target
A low cash rate generally results in a reduction to the interest rate on home loans, car loans, personal loans, business loans etc. Likewise, when the cash rate is high, the interest rate on these loans generally increases.
Therefore, low interest rates are good for people who want to take out a loan.
Fixed Rate Loans
As the name suggests, a fixed rate loan has the same interest rate throughout the fixed rate period. For fixed rate home loans, this period is normally anywhere between one and five years. Sometimes borrowers can secure their interest rates for longer. This loan structure is ideal for borrowers who prefer predictability from their loan repayments, as during a fixed rate, loan repayments generally do not fluctuate.
If you take out a fixed rate loan when interest rates are low, you keep paying the same rate even if rates rise sharply.
As such, many homeowners choose the fixed rate option because it lets them plan their payments.
Fixed rate loans are also popular with borrowers with regular cash flow but are very rate conscious, such as investors who are very yield oriented. A fixed rate may assist this cohort in protecting their rental yield from being eroded by rising interest rates that increase the cost of their loan.
Disadvantages of Fixed Rate Loans
While fixing your interest rate makes sense for some people, you should know that fixed rate loans also have certain disadvantages:
- If interest rates fall during your fixed rate period, you will pay more interest than you would if you opted for a variable rate loan.
- Prospective homeowners should know that a fixed rate home loan may have a higher interest rate than a variable rate home loan.
- Borrowers may pay steep penalties if they exit before the fixed rate term expires. Lenders may not take your reasons for ending the loan into consideration.
- Fixed rate loans are usually more rigid than other types of loans. For instance, lenders may not allow borrowers to make additional repayments, and when they do it is usually capped at a certain amount. Also, redraw and offset options may be unavailable during the fixed rate period.
Variable Rate Loans
Variable rate loans are popular and offered by most lenders. A borrower who has a variable rate loan can change loans and lenders more easily.
The interest that you pay generally varies according to the market rate set by the RBA as well as the lending institution.
Variable rate loans are a popular choice with borrowers who wish pay off their loan quickly. In fact, borrowers can pay off their variable rate loan sooner by making additional payments above the minimum repayment amount without the risk of early repayment penalties. This allows borrowers to save on interest costs as they are reducing their loan sooner.
Variable rate loans are more flexible than fixed rate loans and allow borrowers, not only to pay off their loan as quickly as they wish and to make lump-sum payments, but also provide for redraw, offset and product switching capabilities.
The Disadvantage of a Variable Rate Loan
The main disadvantage of a variable rate loan is that your repayments can increase significantly if interest rates rise. If variable rates increase, borrowers could end up paying more interest than if they had fixed their rate.
Therefore, before taking out a variable rate loan, consider how interest rate hikes may affect your financial situation and goals. Ask yourself whether you’re able to pay more each month should interest rates rise. This is an important question to consider before you decide on a loan structure.
A Compromise: Split Rate Loans
Homebuyers have a third option available to them: split rate home loans. A split rate home loan lets you split your home loan into several loan accounts with different interest rates.
You could split your home loan so that you pay a variable interest rate on one portion and a fixed rate on the other.
For example, if your mortgage amounts to $500,000, you can split your loan into $350,000 at a variable interest rate while paying off the remaining $150,000 at a fixed interest rate. This way you can take advantage of decreases in interest rates on one portion of the loan while enjoying the protection of a fixed rate on the other.
Also, there are no constraints on how you choose to split your home loan. For example, you can split your home loan 50/50, or you can go 20% variable and 80% fixed.
Split rate home loans aren’t without their drawbacks as well. You should know that lenders may charge you extra for this type of loan.
Deciding Between a Fixed and Variable Rate Loan
As we’ve seen, fixed rate loans are normally a good choice for borrowers who value predictable payments and protection from fluctuating interest rates. On the other hand, variable rate loans can be a cost-effective way to promptly pay off debt or enjoy lower payments in the future should interest rates fall.
Whether you choose a fixed rate loan or a variable rate loan, you must take into account your financial situation and the specifics of each loan. This will help you choose a loan that will meet your financial goals.
At Aviator Advisory, we understand that each client is unique and so are their financial goals. However, whatever those goals may be, our team will help you to formulate a lending strategy that will assist you in achieving your goals. If you need help in deciding which type of loan is best for you, get in touch with us and we will find a solution that meets your specific needs.
Disclaimer: The information provided herein is for general information purposes only and does not constitute specific advice. It should not be relied upon for the purposes of entering into any legal or financial commitments. Specific advice should be obtained from a suitably qualified professional before adopting any investment/financial strategy.