What do you choose: fixed or variable?

By Will Keall

One of the most common questions I get asked is which type of home loan to choose: fixed or variable. With interest rates at historic lows, it’s a question I’m being asked even more frequently. Both types have pros and cons and while we cannot predict the direction of interest rates, we can make an informed choice over which type of home loan is most appropriate for our needs.

But don’t think it’s just a contest between these two types. You can also split your loan between fixed and variable and in fact some lenders offer a discounted rate if you do. Splitting your loan means if rates rise, the fixed component of the mortgage will be protected against it. And if rates fall again, then the variable part will enable you to take advantage of lower interest charges.

Some believe you are taking a gamble if you choose to go either wholly fixed or variable so going for a combination of the two enables you to hedge your bets.

Fixed rates are attractive because of the certainty they provide. They provide you with a rate that is fixed for an agreed loan term – generally between one and five years, with the most popular being three. Throughout this period the rate will not change and you know in advance what your repayments will be. This makes it easier to budget and if rates rise, your repayments stay the same.

But on the flipside, you don’t benefit from any fall in interest rates, as you are locked in until the end of your term. Fixed loans are also less flexible; you generally can’t make extra repayments – or the amount you can make is often capped at a low amount. Again, this is where a split loan can be beneficial, as if you are in a position to be able to make extra repayments, you can make these on the variable rate component of your loan.

Something else to note about fixed rate loans, is that you are locked in for the duration of the fixed rate period, and there are costs if you decide to change to a different loan before the fixed-term expires. [The government ban on exit fees only applies to variable-rate mortgages taken out after July 1, 2011]. Borrowers who are concerned about this commitment usually opt for a shorter fixed rate period.

Variable home loans on the other hand, provide you with more flexibility. If the Reserve Bank announces a rate cut, your loan payments are likely to be reduced – although not always to the same extent as the official rate cut, as we have seen over the past few years. You can also make extra repayments, which can help you pay off your loan more quickly.

But if rates rise, so will your repayments – and generally by the full extent of the RBA’s increase. If rates rise dramatically, you may find yourself having trouble making repayments.

These days most borrowers know the Reserve Bank’s decision on whether to raise or lower its cash rate generally feeds into the mortgage rate they pay. But what some don’t understand is that it is only the variable rates that are affected by this decision.

To provide fixed rate mortgages, lenders need to seek funds with relatively fixed costs over longer terms and because of this the cost of funding depends on market expectations of where short-term interest rates will head over the next few years.

So variable mortgage rates depend on where interest rates are now but fixed mortgage rates depend on what the market is expecting interest rates to average over the new few years.

An understanding of this can help you with your decision as to whether to lock into a fixed rate or not. Many experts believe the best time to fix is when the market is expecting rates to stay low for a while longer and the worst time to fix is when the market is expecting rates, which are already high, to rise even further.

Of course, as with the herd mentality of investors who sell when the sharemarket is falling, home loan borrowers tend to fix at the worst time. But is now the right or wrong time? The cash rate is now at historical low levels – 2.75 per cent – and while neither I nor anyone else know what the future holds, fixed rates are more attractive now than they have been for a very long time.

Historically the variable home loan rate has averaged 7 per cent, so if you lock in a fixed rate at below this, then chances are you will come out ahead. At this point in time, some fixed rates are below 5 per cent - below the average variable rate of less than 6 per cent.

Whatever loan you decide to take out, you want it to be competitive. In other words, it needs to be able to work for you – and that means having the features, flexibility and fees that are the most appropriate for your needs.

Will Keall, iMortgage’s general manager, has a wealth of marketing and business development experience gained in Australia and the United Kingdom. These include high level roles in a range of sectors such as financial services, insurance, travel and tourism, motoring and professional services.

Will played a pivotal role in the successful establishment of iMortgage. His dedication and passion for the mortgage industry have won Will the utmost respect as an integral part of the iMortgage brand.

A self confessed “numbers and brand geek”, Will calls himself a conservative investor with a long-term philosophy. He also believes it’s important to “love where you live.”

Will is a cricket and football tragic, who also enjoys running.