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Fixed Rates vs. Variable Rates: What’s The Difference?
●June 11, 2021●5 minute read
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If you’re considering applying for a loan, there are a number of things to understand. One of these is the different kinds of interest rates that you can have. The two main types of interest are fixed interest rates and variable interest rates, which both offer different terms for the life of the loan. Both have their pros and cons, and it’s important to understand these before committing to one. Both types of rates can be attractive to people at different times in their lives.
What is a fixed rate?
A fixed rate loan guarantees a fixed interest rate for the duration of your loan period. This means that, no matter how much interest rates fluctuate, you only have to pay the amount of interest that you agreed on. This secures your repayment amounts for the loan period, which usually ranges 1-5 years. As such, it allows you to predict your future repayments easily. Once your loan period is over, you can choose to re-fix the loan at the new offered interest rates, or you can roll onto a variable rate loan.
A fixed rate loan suits people who like to stick to a budget and want to make consistent repayments. It is important to understand that the fixed interest rate you apply for may not be the rate you are given, though. This depends on a number of factors, including your credit score, income, expenses, and savings.
Importantly, when choosing a fixed rate loan, you should always check the terms and conditions for the variable rate that it will revert to at the end of its fixed term. This can be much higher than expected, and may influence your choice between a fixed and variable rate loan. Fixed rate home loans, car loans, and personal loans are examples of loans which can have a fixed interest rate. Another is student loans. These types of loans are usually at a fixed interest rate, as they tend to have a long-term repayment period.
Fixed rate loans are suited for people who don’t plan on repaying their loan off quickly. They have a number of advantages, which include:
- High rate of certainty;
- No impact to your repayments if interest rates rise;
- Protection from sudden market fluctuations;
- Easy to set repayments and not have to monitor them;
- Easy to budget your repayments and set long-term financial goals.
Like all loan types, fixed rate loans have their downsides too. These include:
- High inflexibility (this is both positive and negative, depending on financial conditions);
- Little freedom and choice;
- Disadvantage when interest rates drop (as you are paying at a higher rate);
- Possible penalties for additional repayments (up to thousands of dollars in break costs);
- Usually no extra features, like redraw facilities (which allow you to reduce your loan balance while accessing surplus funds) or offset accounts.
What is a variable rate?
A variable rate loan does not agree upon a fixed interest rate for the loan period. Instead, the interest rate is continually changing and fluctuating. This is due to external factors, including the Reserve Bank of Australia’s official cash rate, the lender’s market position, and the economy as a whole. As such, the rate of interest you pay is different each time. This type of rate is good for affordable short-term financing. Variable interest rates are seen in mortgage loans, credit cards, and corporate bonds.
A variable interest rate loan gives you access to additional features that fixed rate loans generally don’t have. One of these main features is having no repayment fees and break costs. These can be helpful if you plan on paying off your loan faster than the agreed loan period.
When a mortgage has a variable interest rate, it is usually referred to as an adjustable-rate mortgage (ARM). This is suitable for people who want to pay off their loan in a shorter amount of time than planned, as well as those who won’t be financially hurt if interest rates rise.
A variable rate loan can be well suited to many financial situations. It is useful for people who are okay with taking a risk, and may plan on paying off their loan in a shorter period of time. Some of the advantages include:
- Repayment flexibility (often no break costs for additional repayments or early repayment);
- Easy to refinance (ability to switch lenders if a better rate becomes available);
- Decreased repayments if interest rates drop;
- Ability to redraw available funds from your redraw facility.
A variable rate loan can be a great option for many people. But it does also have its considerations which should be understood before locking yourself in. These include:
- Financial uncertainty;
- Higher repayments when interest rates increase;
- Cash flow uncertainty;
- Difficult to set accurate budgets for repayments and stick to them;
- Difficult to plan financially for the future.
Which one do I choose?
Both fixed and variable rate loans are helpful tools when needing financial assistance. Choosing the right rate for your unique situation is very important. This ensures you aren’t paying too much with your repayments, and helps you reach your financial goals quicker.
If you are needing a personal loan for a special reason, like a holiday or house renovations, a fixed rate loan might be more suitable for you. This is because your monthly repayments will stay the same, meaning you can budget more efficiently. It can provide you with certainty in knowing you can repay the loan over the course of the loan period.
If you are more financially stable, you might want to consider a variable rate loan. This is because you can have more flexibility in making your repayments, and won’t be locked into the loan term by break costs.
Particularly with home loans, the option of a split interest rate is popular. This type of interest lets you take advantage of both fixed and variable interest rates. This works by splitting your home loan into two separate loans – one with a fixed rate and one with a variable rate. The advantage of opting for a split home loan is the flexibility it brings, in letting homeowners be indecisive. It also provides a higher level of certainty, because no matter how interest rates fluctuate, you can have a higher degree of financial security.
If you are unsure which loan type suits you best, you can talk to our team at Jacaranda Finance to compare your options.
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Written by Katie Francis
Katie Francis is a Content Intern at Jacaranda Finance. She is currently studying a Bachelor of Business (Marketing)/Media & Communications at the Queensland University of Technology.