To fix or not to fix — that is the question most borrowers struggle to find the answer to. When choosing a home loan, it is important to weigh your options to ensure that you would not hurt your budget too much in the process of settling repayments. Choosing between a fixed rate and a variable rate could mean thousands of dollars in savings.
Most borrowers are attracted to the certainty a fixed-rate home-loan product offers, especially those who are budget-conscious. In fact, it is advisable for first-home buyers to take on a fixed-rate loan to be able to organize their budgets easily and to stay on top of their repayments.
However, there are some things you have to consider first before you decide to fix your home-loan rate. While these things are not necessarily bad, it pays to know how a fixed rate will affect your home-loan journey.
When fixing your home loan, opt to lock in for a period of three to five years only
The main reason why borrowers fix their loans is to protect them from sudden interest-rate hikes. To make sure that you maximise the interest-rate protection a fixed rate provides, see to it that you only lock in your loan for three to five years.
Do not bother fixing your home-loan rate if you are only going to lock it in only for two years — this would not give you protection from interest-rate hikes. You should also never exceed five years, as fixed rates will only restrict the flexibility of your home loan.
When is fixing your home loan a wrong move?
While a fixed-rate home loan provides you with certainty, there are times when it can turn into a bad idea. When mortgage rates are moving downwards, you will be stuck with your current rate until your fixed-rate period expires. This would mean that you will not be able to take advantage of lower interest rates.
It is also not a good idea to fix your home loan if you do not want to be locked in with a particular lender or mortgage product. Ending your fixed-rate period prematurely usually incurs high exit fees. Unless you think breaking the fixed-rate period will be worth all the effort and money spent, just wait for the term to end before making any changes with your home-loan arrangement.
When you fix your home loan, you will not be able to make large extra repayments — paying your debt within your fixed-rate period will compel lenders to charge you break costs or exit fees. Ask your lender if they have flexible fixed-rate options wherein you will have the chance to make extra repayments not exceeding a set amount annually.
The high exit fee is also enough to discourage you from selling during your fixed-term period. Fixing your home loan when you have plans to sell will only hurt your budget. Refinancing your home loan is also not a good idea if you do it within the fixed-rate period. Plans of renovating or building a new home and using the equity you have on your property are also discouraged when you are in a fixed-rate period.
What are break costs and how are they calculated
Break costs are what you incur for ending your fixed-rate home loan term. These are charged by banks because they usually borrow money from the wholesale money markets through the Bank Bill Swap Rate (BBSW), which is locked in at the same time as your fixed rate.
To put it simply, banks enter a contract with a third party to lock in their funding costs at a fixed rate. When you end your fixed-rate period, your lender suffers a loss. Under Australian laws, you are required to compensate your lender for the loss when you decide to end your fixed rate earlier than expected.
Lenders calculate break costs by determining the difference between the wholesale rates at the time when you applied and when you decide to end your fixed-term contract. This will be multiplied by the loan amount and the remaining term of the loan. The process is complicated but it will be indicated on your contract with your lender.
To give you an idea, here is an example from the Bank of Queensland: Imagine that you have a $300,000 home loan fixed for three years and you paid for the entirety of the loan for only a year and a half. The wholesale rate on the date of the loan was fixed at 3.45%. When the contract was broken, the wholesale rate dropped to 2.23%.
Taking this into consideration, the difference between the two rates is 1.22%. This will be multiplied to $300,000 and the remaining year and a half, yielding break costs of roughly $5,490.
Try fixing only a portion of your loan
In order for you to have the stability a fixed rate provides and the flexibility only a variable rate can give, try to go for a split loan. It will allow you to fix only a portion of your loan.
The fixed part of your loan will still provide the same protection from sudden rate hikes, while the variable part will allow you to make unlimited additional repayments. You can also use an offset account for the variable part of your home loan.