Should you fix or float your home loan?
To help you make your decision, I’ve listed the advantages and disadvantages of each type of loan below.
Fixed Rate Home Loan
A fixed rate home loan is where you sign up for a certain rate for a specified term. e.g. 5.65% fixed for 2 years
Advantages of fixed rate home loans
- Often the fixed term interest rate is quite a bit lower than that of the floating rate. At present, shorter fixed terms of up to 2 – 3 years (depending on which bank), are cheaper than the floating rate. The reason for this is that your bank wants to lock your loan in with them, effectively guaranteeing the interest payment income for the term. Banks offer lower interest rates (even special deals) to get you in the door and then they lock you into a term with them. If you are careful, this can be a win-win for yourself and the bank.
- Rolling short-term fixed rates (6 months to 1 year at a time) have worked out cheaper over the length of the loan (25 – 30 years) than if the borrower had chosen longer fixed terms or floating rates. Someone, a mortgage broker I believe, worked this out so they could advise their customers how to structure their loans.
- Certainty for budgeting. If you have just bought a house, you are probably the most stretched financially that you’ll ever be! If any rise in interest rates is going to make your budget unworkable, then it might be wise in this instance to fix your loan for a bit longer to give yourself some certainty of the repayment costs. Maybe 3 years depending on whether interest rates are going up or down. Problem is no-one really knows which way interest rates will go and they certainly don’t know when the change will occur. If your budget is tight for the first few years, fix the loan at an affordable interest rate for as long as you can. Early on in your home loan, is when you are most vulnerable, so making sure you can afford the payments is vital at this stage, even if it costs you a bit more in interest rate to get that certainty. Once you have more equity in your property and you’ve had a few payrises, things will get easier.
- You can usually still pay a little more than the minimum payment. Check what options your bank will give you regarding slightly higher repayments, or the ability to repay a lump sum. Within some restrictions, you can usually still do something extra to pay your loan off faster.
Disadvantages of fixed rate home loans
- Think very carefully before signing a fixed rate agreement because you are effectively trapped by that agreement. Just as the fixed payments give you certainty, they also give the bank certainty and you will most likely be hit with a large “break cost” fee if you decide to break your fixed rate home loan agreement. Paying off the loan in full also counts as breaking the agreement, so if you are thinking of selling your property, make sure your loan is coming off its fixed term before settlement date!
- If interest rates drop it will be extremely expensive for you to get out of your agreement and sign up to a cheaper one. The costs involved will likely negate any savings you might make on the lower interest rate. If you sign up for a fixed rate loan, just set it and forget it. It doesn’t matter what the rates are doing whilst you’re on a fixed term. As long as you can meet the repayments (and you’ll have worked this out beforehand!) then just keep trucking on.
Banks like their customers to have fixed rate loans because it makes the customer “sticky” and hard for other banks to steal, although in a competitive market, sometimes a competing bank will pay your break costs to get your business, so if you are considering changing banks, do ask about this.
- Longer term fixed rate loans can be expensive. You are paying extra for the security of knowing what your payments will be. If interest rates are likely to rise, the bank will have already factored that in to the pricing of their longer term loans, so all you’re doing is making sure you start paying extra now, rather than taking the risk and paying an increased interest rate later. As mentioned above, the shorter term rates seem to be better value over the long term – even when factoring in short periods of high interest.
Floating Home Loan
A floating home loan has a variable interest rate which will vary and your payments will vary with the interest rate.
Advantages of a floating home loan
- The biggest advantage to floating is that you can pay extra off your loan at any time without penalty. This makes your home loan quite portable if you are considering refinancing to another bank. It’s also likely that you’d choose a floating loan if you have your property on the market for sale because you’ll need to be able to pay off the home loan for the bank to discharge the mortgage at settlement.
Disadvantages of a floating home loan
- Cost – the interest rate is usually quite a bit higher. Banks don’t like the idea of you being able to pay off the loan at any time. That is a risk to them.
- The rate will vary with market conditions, so you don’t have certainty over your repayment costs. Rates seem to go up faster than they come down too!
- There is less competition on floating interest rates because banks don’t gain any certainty by acquiring your floating loan. The banks don’t want to compete to win business that can easily be taken away from them again.
So where are interest rates heading? What should I do if my fixed rate loan is coming up for review in the next month or so?
It’s really anyone’s quess when interest rates will go up. Here in New Zealand the long-run average is around 8%, so we are in a period of low interest rates at the moment. If you can afford for your payments to increase with rising interest rates, and you’re not looking to sell or refinance, then I’d suggest going for a shorter term (6 month to 1 year) fixed rate if you can get a really good deal. The idea is to make the most of the lower rates to pay down more principal. If your bank will let you pay off a bit extra each payment on a low fixed rate, then that’ll be saving you a lot over the life of the loan.
If you are thinking of selling shortly, then you don’t have a lot of choice but to float your loan to keep that flexibility.
Why not have a combination of both types?
You can have the majority of your loan on a short term fixed rate, and some of your loan floating so that you can make extra payments as often as possible. Regardless of the interest rates, your aim is to get rid of your loan as quickly as possible, so don’t get too hung up on the rate, but on your ability to shorten the term of your loan. You can use Sorted, or your bank’s calculator to see how much quicker you can pay off your loan if you pay more than the minimum repayment.