The interest rate on a home loan can be either fixed or variable, but in both cases the periodic repayments include both a portion of the loan principal and interest as well.
Fixed interest rate
As the name implies, fixed home loans have an interest rate that does not change during the fixed rate period, which may be the first 1-5 years of the loan's term, before reverting to a variable rate for the remainder of the term.
During the fixed rate period, monthly repayments never change, and are easier to budget for. But in an interest rate environment where rates generally are falling, having a fixed interest rate could lock you into paying more in interest than you would with a variable rate.
Variable interest rate
Home loans with a variable rate may have a variable interest rate from the very beginning, or revert to a variable rate once the fixed interest term expires. A variable rate can go up or down, often – but by no means always –in line with a change in the Reserve Bank's official cash rate.
Home loans with variable interest rates more difficult to budget for because monthly repayments will vary, but it will benefit the borrower in a market environment where interest rates generally are falling.
Variable interest rate loans also have additional features not generally available with a fixed rate loan, such as an offset bank account and an extra payment and redraw facility.
Offset bank account
An offset bank account is often offered by bank lenders in conjunction with a variable interest rate loan. It operates in the same way as a standard bank transaction account, except that any positive balance in the account is taken into consideration when calculating the interest payable on the remaining home loan principal.
For example, if you had a remaining home loan principal of $345,500, and a deposit balance of $6,250 in your offset account, interest on your home loan at that point would be payable on an amount of $339,250 (i.e. $345,500 minus $6,250), not the full loan principal amount of $345,500.
Extra payment and redraw facility
An extra payment and redraw facility is a further feature often accompanying a variable rate home loan. It gives you the option of making additional loan repayments when you have spare cash available (from a tax refund, for example) to reduce the loan principal. It means that you will pay less interest in total because you will shorten the time it takes to repay the loan in full.
Should you find, at a later date, that you need access to that extra cash you committed to your home loan, you can withdraw it, usually without penalty, if you also have a redraw facility.
Fixed rate home loans do not normally come with offset accounts and extra payment options, or if they do, there may be significant additional fees involved. That's because the bank has calculated the amount of profit it needs to make on the loan and built it into the fixed interest rate. Offset account and extra repayment options erode that profit and could even turn it into a loss unless extra fees are charged.
Working out which kind of rate is best for you
Whether you decide to go for a variable rate from the start of your loan, or a fixed rate reverting to a variable rate, largely depends on how much budgeting certainty you require in the early years of your loan, and whether you can make good use of the flexibility offered by an offset account and extra payment and redraw facility.
Your credit score will significantly affect the rate you are offered
There are several factors that determine the interest rate your are offered on your loan. They are:
- Your credit score
- The price of the home
- The amount of your deposit as a percentage of the home's value as assessed by the bank
- The loan term
- The interest rate type
- Whether you are an owner-occupier or an investor
Your credit score tops the list because it's usually the most important factor. An excellent credit score will help to secure you a low interest rate, while a poor credit score will see you being offered a much higher rate and make getting loan approval more difficult.
If you're in the market for a home loan you should monitor your credit score constantly, which you can do free of charge right here at Finty. We can also help with some tips on improving your credit score.