Variable vs Fixed Rate Home Loan
It’s finally happened. The Reserve Bank of Australia (RBA) has raised the official cash rate for the first time in more than a decade in response to Australia’s rising inflation rate.
Many analysts are tipping more interest rate rises to come over the next couple of years, but no one can predict with certainty what will happen. Just last year, the RBA Governor predicted that there would be no rises of the official cash rate until 2024. The error of that prediction shows how quickly the financial environment can change.
Read on to find out about current fixed and variable interest rate market conditions, the implications of any future interest rate changes, as well as considerations to make before you fix your home loan interest rate.
Variable vs Fixed Rate Home Loan
Fixed interest home loan rates available at any given time have always factored in the potential for future interest rate rises. Depending on the type of loan and the term, fixed rates can be 2 or 3% higher (or even more) than the lowest variable rate home loan you can get.
This means that it would take a number of interest rate rises for today’s premium of fixing your rate to pay off — and not only pay off, but it would also take many rate rises for you to match where you would have been had you stuck with variable. If you lock in a fixed rate today, you’ll be paying a much higher amount in interest than you would pay with a variable rate. If the RBA increased the cash rate every single month until the variable rate equalled the fixed rate you locked in, you would still be losing out, because you would have just spent all that time paying a higher rate than you would have if you were on a variable rate. The interest rates would need to continue to consistently rise for perhaps years before the decision to fix would pay off.
Ultimately, whether you would be better off taking out a fixed rate home loan compared to a variable rate one depends on how many interest rates rises we have in the near future in Australia, and the size of each one. The latest interest rate rise was 0.25%, so you would need several interest rates increases of that amount to happen over the next year or two to be better off locking in a fixed interest rate now.
The table below illustrates your principal and interest repayments and how much interest you would pay at a 2.5% variable rate versus a 4.5% fixed rate on an average-sized Australian home loan of $600,000 over 30 years.
As you can see, taking out a fixed rate at today’s (hypothetical) interest rate would end up considerably more expensive if the variable rate remains low. And let’s say interest rates rise every month by 0.25% for the next eight months, where the variable and your fixed rate are both 4.5%, had you fixed eight months prior, you would’ve just spent all that time paying a much higher rate. On a variable rate you could have paid 2.5%, 2.75%, 3.00%, 3.25% (and so on up to 4.5% each month), but instead you paid 4.5% consistently every month — which has gotten you further behind.
Tips for futureproofing yourself against variable interest rate rises
Let’s look at some other strategies for futureproofing yourself against interest rate rises that won’t involve you locking into a fixed rate period.
Tip 1: Start making higher regular repayments now.
This will help you to budget for increased repayments in the future if interest rates rise. It will also help you to get ahead and reduce the amount you owe, so if rates rise you’ll be charged the higher rate on a lower overall loan amount.
Paying a higher amount on a variable rate, (let’s say you pay an amount equal to the fixed rate) helps to build a cash buffer. If rates rise, you’ve chipped away at the principal, helping you get ahead, if they don’t rise, you’ve built up a cash reserve that can be accessed when you need it. Fixed interest rate home loans do not provide the option to build a significant cash buffer that can be built with a variable rate.
Tip 2: Put any surplus, irregular money you receive into your variable home loan.
If you get one-off windfalls like bonuses, commissions, tax refunds, a government lump sum payment, or an inheritance, that money could be used to offset the interest on your home loan by making extra repayments — something that generally isn’t possible when locked into a fixed period.
Again, this will help you to get ahead if interest rates rise.
If you have (or you set up) a redraw facility, you could withdraw that money if you need it later. (Features like this often aren’t available with fixed rate loans.)
Tip 3: Put any surplus, irregular money you receive into your offset account.
If you’d prefer to still have ready access to your one-off windfall, you could put that money into your offset account if you have one (or you could set one up). The money in your offset account will be deducted from your home loan balance when your home loan interest is charged, so you’ll pay less interest than you would (especially if rates rise).
While fixed rate home loans could provide certainty and consistency regarding your repayment amounts, it could also be unnecessarily expensive compared to variable rate loans. Strategies to save money and reduce your home loan balance can futureproof you against variable interest rate rises. They are an alternative to fixing your home loan at a higher rate.
“If you would like to review or refinance your existing home loan, whether a fixed or variable rate loan, our home loan experts are just a click away to ensure you’re getting the right deal, please get in touch.”