Interest rate: Fixed or variable?
Interest rates in Australia are at record low levels, a fact which has had both positive and negative knock-on effects in the property market. In addition to public debate around housing affordability, the discussion around interest rates generally circles back to a key question – should you go fixed rate, variable, or somewhere in the middle?
Whether you borrow at a fixed or variable interest rate or a blended option depends on your personal circumstances. All have their pros and cons:
Variable rate
The advantage of this option is flexibility. You can repay the debt at an accelerated rate or in full without penalty. When the Reserve Bank of Australia (RBA) cuts their cash rate, your lending institution may reduce your variable interest rate. When the RBA increases the cash rate, you will pay a higher price for your loan.
Fixed rate
A fixed rate debt provides a level of certainty and takes interest rate volatility out of the equation. However, fixed rate loans can be expensive to restructure. They also limit the quantum of additional repayments during the fixed period.
Blended interest rate
This option splits the loan between variable and fixed interest. The split does not have to be a perfect 50%/50% between fixed interest rate and variable rate – the split ratio will depend on your short-, medium- or long-term goals.
With the blended option, you have certainty on the fixed rate portion of your borrowing while allowing for market changes upwards or downwards on the variable interest rate component. You also have the flexibility to repay the variable interest rate debt component at your discretion without penalty.
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What happens when you break a fixed interest rate home loan?
Jane bought a home and locked in the interest rate for three years. Twelve months later, Jane was offered an exciting career opportunity in New York and decided to sell her Melbourne home.
During the initial 12 months of Jane’s loan, the fixed rate had reduced. To break the loan before the end of the 3-year term meant the fixed interest rate contract would be deemed out of money and Jane would be up for break costs.
The break cost of a fixed term loan is determined by the remaining duration of the fixed-rate contract and the differential between the current fixed-rate contract and the prevailing fixed-rate contract interest value. If the prevailing fixed-interest rates had increased during the 12 months, Jane’s existing fixed interest rate contract would have been deemed in the money and Jane’s financial institution may have paid her a cash benefit.
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