The things to consider when deciding between a fixed and variable interest rate include:
- Do you expect to sell the property in the next couple of years?
- Are interest rates going down or up?
- Do you want to know what the repayments will be each month for the next couple of years so you can budget for them?
- Do you want to make extra repayments on the loan?
- If you have made extra repayments, do you want to be able to withdraw that money?
That looks like a lot of things to think about but it really boils down to whether you want flexibility with this loan. Fixed interest rates are great for a loan that you want to set and forget and they can give you peace of mind when interest rates are going up. But are fixed interest rates the best option for you? Let’s take a closer look at them and see.
A drawback with a fixed interest rate is that it can be expensive if you decide you need to change the loan. This is because if you end the loan agreement, the lender is missing out on interest that you had agreed to pay. So they will charge a ‘break’ fee if you break off the arrangement before the end of the fixed term so they don’t end up out of pocket.
For example, Sue and Max are getting married. Sue has an investment property that she wants to sell so they can buy a family home. But 2 years ago, before she met Max, she took out a 3 year fixed interest rate loan on the property. The property is valued at $320,000 and has a loan of $200,000. The interest rate of her current fixed rate loan is 5.5% and the fixed rate offered by her bank today is 3.99%. To get an accurate ‘break cost’ for the loan Sue would need to speak to her lender, but we can calculate an approximate value using some simple calculations. By understanding the break costs, Sue can make a decision on whether to end the fixed rate loan early so they can buy their home now, or wait until the end of the fixed loan term.
Firstly, collect the details about the loan:
|Fixed period||3 years|
|Months left on fixed term||12|
|Fixed loan interest rate||5.5% (0.055 for calculations)|
|Lender’s current interest rate for 3 year fixed loan||3.99% (from your lender’s website)|
|Interest due for the rest of the current fixed term
(put the number of months left on the loan in place of the bold 12)
|$200,000 x 0.055 x 12/12 = $11,000 (A)|
So let’s use those figures to calculate the estimated break cost:
|Fixed rate on the loan – current fixed rate
Fixed rate on the loan
|5.5 – 3.99
5.5 = 0.275
|Now multiply by the interest to be paid for the rest of the current loan term (see A above)||
0.275 x $11,000
|Break fee||= $3,020|
(If you’re not confident doing the calculations yourself, just send through the loan details to me in my Enquiry Form and I will calculate them for you.)
So Sue can now assess whether they can afford to spend $3,020 on break fees. Her decision might be influenced by how much money they have in savings, whether they have found a house that they really want to buy now, and what they expect local house prices to do over the next 12 months while they wait for the end of the fixed term.
Break Fees When Interest Rates are Increasing
Now, the example above uses a situation where the interest rates have dropped since Sue took out the loan. But if the fixed interest rates have increased since the start of the fixed period it can make a big difference to the break costs, as you’ll see below.
Jane and Mark took out a 5 year fixed loan for $500,000 with an interest rate of 4.5%. They are interested in increasing the loan on their home so they can do some renovations and want to know what the break costs would be if they refinanced their loan now.
Again, we collect the details about the loan:
|Fixed period||5 years|
|Months left on fixed term||18|
|Fixed loan interest rate||4.5% (0.045 for calculations)|
|Lender’s current interest rate for 3 year fixed loan||6.2% (from your lender’s website)|
|Interest due for the rest of the fixed term
(put the number of months left in place of the bold 18)
|$500,000 x 0.045 x 18/12 = $33,750 (A)|
Now let’s use those figures to calculate the estimated break cost:
|Fixed rate on the loan – current fixed rate
Fixed rate on the loan
|4.5 – 6.2
4.5 = 0 (if the result is negative, the outcome is zero
|Now multiply by the interest due for the loan term (see A above)||
0 x $33,750
|Break cost||= $0|
So in this case, the interest rate had gone up from 4.5% to 6.2%, so anyone taking out a new 5 year fixed loan now with their lender would pay 6.2% in interest. That means that the lender would be happy for you to take your loan out of the fixed rate, because they can give a new fixed rate loan to someone else at 6.2%!
This would be an easy decision for Jane and Mark because there will be no additional break costs for them to pay to refinance the loan, even though they were still part way through a fixed rate loan.
So you can see that the difference in interest rate between when you start the fixed term and when you want to ‘break’ the term are very important and can make a HUGE difference to whether you have to pay any additional break fees. If rates have stayed the same or decreased then knowing what the break fee will be allows you to work out whether you want to change the loan now or whether you would be better to wait until the end of the loan term. Everyone’s different, and it depends on why you want to break the fixed term, and what the benefits are to you. So if you are thinking about changing your fixed rate loan, calculate the costs first so there are no nasty surprises!
Fixed Rate Loans with Flexibility
Most fixed rate loans are fairly basic loans in that they don’t allow you to do much with the loan during the fixed term. If you have made extra repayments you can’t withdraw that money during the term of the fixed rate just because you need it for something else. If you want to be able to make extra repayments off the loan, some lenders allow it, they just put limits on how much you can pay off during the fixed term. At the moment here are the amounts of additional payments you can pay off fixed loans with these lenders (as long as it doesn’t result in you paying off the whole loan during the fixed term):
National Australia Bank: $20,000 during the fixed term (whether the fixed term is 1 year of 5 years the same limit applies)
ME Bank: Up to $30,000 during the fixed term.
AMP: Up to $10,000 per annum
Adelaide Bank: Up to $20,000 per annum
Beyond Bank: Up to $25,000 per annum
So if you are expecting to come into a sum of money during a fixed term loan, it is worth building that into the plan so we can make sure that you can pay it off the loan if you want to, when you want to. Maybe you are planning to sell a property or some shares, will receive a big bonus from work, or an inheritance. If you knew you would receive a windfall of $30,000 during the course of the loan and you wanted to pay it off the loan, we could, for example, look at placing your loan with ME Bank so you could make one payment of $30,000, or look at making lump sum payments of less than $20,000 in any particular year with Adelaide Bank or Beyond Bank. With AMP we would need to split the additional payments over 3 years. As you can see, it’s important to consider any changes in your circumstances that will, or could, occur during the term of the fixed interest rate loan.
If you were coming into a larger sum of money that you wanted to pay off the loan you may be better to stay with a variable loan so you could pay extra off the loan at any time, or we do have one lender who offers an Offset Account against a fixed interest rate loan. This lets you put the extra funds into the offset account and then they take that amount away from the loan balance before they calculate the interest rate. Of course since only one lender offers that option it means you can’t shop around for the best interest rate, but I can compare the various options for you to work out which one costs less over the term of the fixed loan.
So as you can see it’s important to look to the future when taking out a loan with a fixed interest rate because there are differences between lenders that can influence whether a particular loan meets your needs or not.
I hope that gives you a better understanding of fixed rate loans. Do you have any questions or maybe you’ve had an experience with a fixed rate loan that you’d like to share? We’d love to hear it!