When you take out a mortgage one of the decisions you will have to make is between a fixed and variable interest rate, or a combination of the two. Before you make your choice, it’s important to understand the difference between the two types of interest rates.
The type of rate you choose will depend on your view of how the Reserve Bank of Australia’s (RBA’s) cash rate will change over time. This is one of the most important variables to determine how interest rates change. If the cash rate changes, so too will variable interest rates set by financial institutions, and they will change in line with the direction of the cash rate.
Fixed interest rates
If you choose a fixed interest rate, you will decide to pay the same interest rate for a defined period. For instance, your bank may offer you a 4.5 per cent interest rate on your mortgage for a period of three years.
Generally, you will choose to fix your interest rate if you believe interest rates will rise to lock in a lower rate for the term of the loan.
If you choose a fixed rate, your payments will stay the same for the period of the loan, no matter how the RBA’s cash rate changes, giving you certainty about how much you will pay each week, fortnight or month.
Fixed rate home loans are generally less flexible than variable rate loans. In general you can’t pay off extra over time, or draw down on extra repayments you make. But they do give you certainty over the amount you pay every time you make a payment.
Variable interest rates
If you select to pay a variable interest rate, your interest rate will usually change when the RBA changes the cash rate. It can also change at other points, for example if banks’ cost of funding changes.
You would choose a variable interest rate over a fixed interest rate if you believe rates will go down. This will usually mean your interest rate will fall when the RBA’s cash rate falls. Your payments will change when this happens.
Variable home loans are often more flexible than fixed home loans, allowing you to make extra repayments if you are able to, and access any additional amounts you have paid off the loan.
Many people choose a combination of a fixed and variable home loan to achieve a ‘best of both worlds’ situation. This allows the borrower some flexibility over making additional repayments, but also gives certainty over a portion of the loan. It’s a good idea to talk to your financial institution about the right type of loan for you.
About the author
Alexandra Cain is a finance journalist who contributes regularly to The Australian Financial Review, The Sydney Morning Herald and The Age.
Please note that this article is not financial product advice and does not take into account any person’s individual objectives, financial circumstances or needs.
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