Fixed or Floating?
Typically, fixed interest rates are lower and floating interest rates are higher but that's only one factor to take into account when making this important decision.
Fixed interest rate loans
A fixed interest rate loan allows you to fix the interest payable on your loan for a set period, from six months to five years. Lenders generally offer lower interest rates for fixed rate loans.
With a fixed interest rate, your payments stay the same for a set time. You have the confidence of knowing that you won't be affected by rises in floating interest rates - which are generally higher. But if interest rates fall, you will still be locked in to your regular repayment level for the period you have agreed with your lender. You can break a fixed interest rate arrangement by repaying early but there are costs involved.
When a fixed rate period ends, lenders will automatically move you to a floating rate loan, unless you agree to a further fixed rate period. Most lenders send you a letter a few weeks before your fixed rate period is up.
Most lenders place limits on lump sum repayments that can be made with a fixed rate loan. For example, you may be limited to repaying no more than 5% of the loan principal in any 12 month period. There may also be limits on increases to your regular loan repayments during a fixed rate period. These restrictions may suit you when you first take out the mortgage but may not meet your needs later on.
Floating interest rate loans
A floating rate (or ‘variable interest rate') is when the interest rate can vary with the market, so your repayments may go up and down. There is no set period for a floating interest rate other than the total loan term. Most lenders have a 25 to 30 year limit on how long you can take to repay the full loan.
The interest payable on a floating interest rate loan varies depending on market conditions, represented largely by Reserve Bank changes to the official cash rate. This means the interest rate of your loan will increase or decrease from the rate at the time your loan is arranged.
Floating rates are normally higher than fixed rates but provide you with the flexibility of lifting your regular repayment amounts or making lump sum payments throughout the term of your loan. Some lenders have set minimum levels for lump-sum repayments - usually between $1,000 and $5,000.
So how do I choose?
Whether you choose a fixed interest rate loan or a floating interest rate loan depends on your answers to a number of questions. You could start out with some economic questions:
- Do you think interest rates will keep going up, and if so, how long do you think that will continue? The answer to that question may give you some guidance on whether you want to fix your interest rate and for how long.
- Do you think there'll be a drop in interest rates and if so, when? In this instance would a floating interest rate be a better option for you?
Economic questions aside, there are 'life' questions that you'll need to consider:
- Where are you in your life path? Are you a first home buyer with tight finances and in need of budgetary certainty for your repayments, or are you well settled and wanting the flexibility to use your bonuses to repay lump sums?
- Are you a graduate with compulsory student loan repayments?
- Do you have plans for more children and a larger home in the near future? Or do you have children who will be leaving home in the near future, allowing you to downsize to a smaller home?
- Do you need some flexibility to redraw principal to do home improvements or buy that boat you've had your eye on?
- Is your loan for an investment property and do you want to be able to redraw principal for maintenance?
- How long do you think you'll keep the property? Is the property you're buying the best property you could find in the current market but you'll only hold onto it until you find your dream home?
Splitting your loan - a mix of fixed and floating
There are no simple answers. To deal with this complexity you can split your total borrowing into one or more loans, with some of the loan on a fixed interest rate and part on a floating rate. This spilt gives you certainty over most of your loan repayments for a set time as the fixed payment amount remains the same.
The fixed interest component is most useful for budgeting purposes and can be re-assessed as the fixed term expires. The floating interest rate portion gives you the flexibility to make lump sum repayments and to redraw within the loan limit when you need to.
