A fixed rate home loan is more complex than you might think and we need to cover a lot of points to completely understand whether you should stay with a variable rate or fix your loan for a few years.
Over the past few years we have all seen the effects of the global financial crisis affected interest rates dramatically. Rates plummeted from around 7.5% to 4% or 5% depending on the lender. This uncertainty confused many borrowers, especially when it came to deciding whether or not to choose a fixed rate home loan.
When To Choose a Fixed Rate Home Loan
It is normally a golden rule of borrowing that when rates are going down, it is not a good time to fix your home loan. Nevertheless, with the uncertainty in the market many borrowers jumped on the fixed rate bandwagon.
Compare this to the situation just prior to the onset of the global financial crisis. With rates hovering around 7.5% and are looking to go higher, many borrowers chose to fix their home loans at that point. This meant that when rates began to fall, they were stuck on high rates sometimes as much as 3% above the going market rate.
These borrowers found themselves in a real bind and sought to get out of their fixed rates and go back onto a variable rate home loan. Unfortunately, this is when the small print of fixed home loans really hit home.
So, before we jump into the ins and outs of whether or not a fixed rate home loan is good for you, let’s take a look at how fixed rate home loans really work.
The most salient points about a fixed rate home loan are as follows.
- Most lenders offer fixed rates for 1, 2, 3, 4, or 5 years. Some of the major lenders will go as high as 10 years or even 15 to 20 years depending on the circumstances. This means you have many choices to make.
- All fixed rate home loan contracts lock you in to the term you choose. This means that if you wish to terminate the fixed rate term earlier than normal there will be penalties attached. The actual amount of the penalty is difficult to ascertain but as a rule of thumb if the variable rate is lower than the fixed rate, the greater the difference the greater the penalty. Naturally, if the fixed rate is lower than the variable rate there is unlikely to be any penalty if you want to terminate your fixed-rate home loan early.
- There are restrictions on the amount of extra repayments you can make on a fixed rate home loan. This means that you don’t have the flexibility as you do with the variable rate home loan by making extra payments to pay the home loan off earlier.
- One of the advantages of a fixed rate home loan is that there is no uncertainty in your cash position. You will know exactly how much your monthly home loan commitments are because interest rate changes do not affect you in the slightest.
What these points really mean will change according to your own particular circumstances and the prevailing conditions in the interest rate market.
In essence, choosing to take a fixed rate home loan means you are taking a gamble. You are gambling as to whether the interest rate will be going up or down, and if you are correct you stand to save a lot of money. On the other hand if you are wrong, you stand to lose thousands of dollars or even more.
At the height of the global financial crisis when variable rate home loans were at their lowest ebb, many fixed-rate borrowers who sought to terminate the contract early discovered they were up for tens of thousands of dollars in early repayment fees. This was the worst of all worlds and many borrowers faced extremely difficult times.
This should sound a warning to anyone contemplating a fixed rate home loan for a long term.
Let’s summarise the position so far.
The advantages of taking out a fixed rate home loan are:
- You can plan your budget a long way in advance because you know that 30 monthly home loan repayments will not change.
- Fixed rates can give you peace of mind especially when you have to budget for things like school fees or other recurring expenses.
- If variable interest rates rise, you will save a lot of money.
The disadvantages of fixed rate home loans are:
- If variable interest rates rise, you could lose a lot of money.
- If you decide to sell your house, or you want to pay out your fixed-rate home loan and convert to a variable rate you could face very high termination fees as we have discussed above.
- There are restrictions how much extra you can pay into your home loan, which means you may not be able to pay off as soon as you would like.
- Most fixed rate home loans do not come with ‘frills’ like offset accounts, which means that you have less opportunity to save money.
Variable rate home loans have several advantages:
- When interest rates fall you can save a lot of money.
- Generally, you can pay as much as you like into your home loan whenever you like which means you can pay it off sooner.
- You can take advantage of facilities like offset accounts which can help you reduce interest payments and help you pay off your home loan sooner.
- Many lenders offer professional packages which offer discounts on variable rate home loans that are not available on fixed rates.
But variable rates also have some disadvantages:
- As interest rates rise, you may find it a struggle to keep up with a home loan repayments.
- Your lifestyle can be severely restrained if rates continue to rise over a sustained period of time.
All in all, you need to make some carefully considered judgements before deciding to opt for a fixed rate home loan.
Remember when you are taking out a fixed rate home loan you are saying to the bank: “I bet the variable rate will be higher than this for the next x years”.
And the bank is saying back to you: “we bet it won’t!”
Banks have been wrong in the past and they are likely to be wrong in the future at some stage, but you can minimise the gamble before deciding whether a fixed rate home loan is best if you talk to some experts before making your decision.
