Home loans variable vs fixed rates

In 2022, something dramatic happened to 60% of Australian homeowners. Their monthly mortgage payments skyrocketed Aussies that bought a median $700,000 property saw their payments rise by $1,000 a month. Those who bought a typical Sydney or Melbourne home worth $1.2 million saw their payments rise by $1,700 per month.

What separated these homeowners from the 40% who saw no change in their repayments? The difference was they chose a variable interest rate home loan, rather than a fixed interest rate.

Variable vs. fixed rate home loans

Variable rate loans can have their interest rate change from month to month. If the interest rate goes up on the loan, so do monthly repayments. This happens due to decisions made by the Reserve Bank of Australia (RBA), and it’s what’s happening when you hear that the RBA is raising interest rates.

Similar increases have occurred in New Zealand, where the Reserve Bank of New Zealand has chosen to raise the official cash rate.

Fixed rates on the other hand do not change month to month. Their interest rate is fixed until the loan matures, which is typically 1-5 years in Australia and New Zealand, and won’t change no matter what the RBA decides. In 2022, this paid off big time for those that took out fixed rate mortgages at rock-bottom rates in 2020 and 2021.

So, if it was such a good deal, why didn’t everyone take out fixed rate mortgages in 2020-2021? As is often the case in finance, the answer lies in understanding risk.

Who takes the risk?

The core difference between a variable and fixed home loan is who carries the interest rate risk – who pays extra if rates rise. If you choose a variable rate loan, it means that you carry the risk and have to shoulder the burden of rising interest rates. If you choose a fixed rate loan, then the bank takes this risk for you.

Of course, in exchange for taking this risk, the bank asks for something in return. If they think rates will rise, they’ll add a premium to the fixed rate. For example, in early 2023, fixed rates are currently a few percentage points higher than variable rates. They’ll also demand stricter loan terms, limiting your opportunities to refinance or pay your loan off early.

But even fixed rates can’t be fixed forever. The most you can typically fix for in Australia and New Zealand is 3-5 years, so even repayments on a fixed loan could eventually rise.

The flip side: benefiting from variable rates

Our example above showed how taking on risk with a variable rate loan turned out badly for homeowners in 2022. But, wind the clock back just a couple of years and we see the reverse. Those that took out variable rates in 2019 saw their interest rates decrease in 2020 and 2021, meaning cheaper mortgage payments than those that fixed their interest rate.

What’s the best option?

When taking out a mortgage, it can be tempting to just pick the option with the lowest interest rate right now. But, you need to think through the amount of risk and loan flexibility that’s suitable for you.

Ask yourself these questions as a starting point:

1. Could you afford your repayments if they were to rise significantly in the next five years?
2. Would you benefit from greater loan flexibility, such as the ability to refinance or pay the loan faster without incurring fees?
3. How much would interest rate certainty affect your peace of mind?

General advice disclaimer

The information contained in this document is provided for education purposes only. It has been prepared without taking into account your particular financial needs, circumstances or objectives. You should consider the appropriateness of the information as it relates to you. You may wish to consult an adviser before you make any decisions relating to your financial affairs.