What Is the Difference Between Variable and Fixed Rate Home Loans?

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Major Australian lenders, including Commonwealth Bank, offer multiple loan options to accommodate a wide range of potential home buyers. These loan options often include the choice between variable and fixed rate home loans.

Understanding the Basics of Interest Rates

Before exploring the differences between variable and fixed rate loans, you should understand how interest rates work. When calculating your payments, lenders use an amortisation formula to balance the principal and interest throughout the life of your loan.

At the start of the loan, most of your payment goes to interest and a small amount is applied to the principal. Over time, the remaining balance of your loan decreases as do the interest payments, allowing more of your monthly contribution to go to the principal balance.

The amortisation formula helps lenders calculate a monthly payment that stays the same throughout this period. However, if you choose a variable rate loan, the interest rates and your payments may change. For example, according to Lendi the lowest interest rate offered by Commonwealth Bank over the last 12 months was 3.79%.

Payments for Variable Rate Loans May Vary

With a variable rate loan, your interest rate is based on an interest rate index. If the index decreases, your interest payments decrease. If the index increases, your interest payments increase. In Australia, lenders often rely on the cash interest rate set by the Reserve Bank of Australia to determine variable rates.

Changes in the index can lead to changes in your monthly payments. However, Commonwealth Bank and other Australian lenders often include a fixed interest rate for a period at the beginning of the loan. This fixed interest rate typically lasts for one to three years, depending on the terms of the loan.

Fixed Rate Loans Provide Consistent Payments

With a fixed rate loan, your monthly payments may remain relatively the same throughout the life of your loan. While the interest rate does not change, property taxes and other fees may vary slightly, resulting in minor fluctuations to your monthly payments over an extended period. However, the amount you owe remains more consistent compared to a variable rate loan.

The consistency is the primary advantage of a fixed rate loan. Regardless of the current interest rates, your rates remain the same. The drawback to this type of loan is that if the going interest rates drop significantly, you are left with a higher interest rate.

Which Type of Home Loan Should You Choose?

The type of loan you choose may depend on several factors, including your loan-to-value ratio (LVR) and current credit standings. If lenders consider you a high risk, you may have trouble getting a low fixed interest rate. A variable rate loan often allows potential home buyers with a high LVR and limited down payment to qualify for a loan.

Both variable and fixed interest rate loans have their advantages. The bottom line is that a variable rate loan may provide an opportunity for you to purchase a home even without a substantial down payment. These loans may also result in lower payments over the life of your loan if the cash interest rates decrease. Keep these details in mind as you begin comparing loan options.