Applying for a housing loan or personal finance loan represents one of those big life steps that require careful planning. Once you’ve decided to make this step, one of the key decisions that will define how you organise your budget in the coming months and years is selecting between a fixed and a variable rate. The interest rate selected will affect your monthly payments, your total interest expenditure and your general financial state.
Knowing all the pros and cons associated with each of the rates and understanding how they behave when influenced by the general economy allows you to choose a loan product that suits your individual needs.
Fixed Interest Rate
This kind of rate allows the borrower to lock in their repayment amount for a fixed number of months or years. The biggest strength of such a loan product is its predictability. Monthly payments are always known in advance and the borrower does not need to worry about rate fluctuations affecting their financial situation. Such rates protect from interest increases introduced by the Reserve Bank of Australia.
There are several disadvantages of using a fixed rate. Should the national interest rates decrease, the borrower will continue paying the initially agreed amount throughout the whole period of time defined in the loan terms. Banks typically impose large break fees on borrowers wanting to sell their property, refinance their credit or perform significant additional repayments.
In general, a fixed interest rate is recommended for borrowers on tight budgets. If the slightest interest rate change can negatively affect the borrower’s financial situation, a fixed rate offers a certain kind of protection.
Variable Interest Rate
A variable rate fluctuates depending on the economic situation and on the decisions made by the lending institution. The obvious upside of having a variable rate is flexibility, as there are no restrictions on the number of additional repayments the borrower can make. Most lenders also provide various financial tools such as redraw facilities or offset accounts that can help a person repay their loan ahead of schedule.
As for the downsides, there is an ever-present risk that the rate will change and the monthly payment will become larger. As a result, some budgeting is required in order to prepare for potential interest increases.
In general, variable interest rates are recommended for those borrowers who have enough free budget and are able to deal with any potential changes without compromising other areas of their lives. People who actively use their bonuses and salary increments to pay down their debt also should consider applying for a variable interest rate.
Choosing Between Fixed and Variable Rate
In addition to the borrower’s financial priorities, several factors should influence the choice of a loan product. Market conditions are among the strongest reasons why a particular rate should be selected. If the national interest rate has fallen significantly recently and is expected to increase soon, applying for a fixed-rate loan could save some money for the borrower.
Borrowers interested in selling their homes within the next couple of years or changing their lifestyles should opt for the more flexible variable rate. It could potentially save on expensive break fees.
Lastly, the borrower’s risk appetite should be considered. People who feel comfortable with the idea that the repayment will not change regardless of the economic climate are likely to select the fixed rate. When it comes to credit cards, you also have the option of interest free period credit cards, and this can save money in the short term and allow you to solidify your finances before the interest rate kicks in.
Conclusion
Choosing the right rate does not have to be difficult. With a proper analysis of one’s current financial state, market environment and risk tolerance, it is possible to pick a loan product that would suit one’s needs and bring the most benefits. For instance, it is sometimes useful to split a loan product into two parts: a fixed and a variable rate.
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