The topic of home financing is a convoluted one. There is plenty of scope to cover, even for an introductory note. In my experience, the best approach is to compartmentalise this subject matter into a series of digestible posts. With that said, I’m delighted to present a home financing series, covering the ins and outs of this topic. For starters, this series begins with discussing the most appropriate loan type available to borrowers: fixed home loans versus variable home loans.
Before commencing this series, I would caveat that I am not a certified financial advisor or mortgage lender. Any information provided below is solely based on my own experience and personal research. I strongly encourage you to consult a professional advisor before entering into a mortgage or other debt arrangement.
Fixed home loans, by definition, are home loans that have a set interest rate for the loan term. A 15-year mortgage with an interest rate of 3 percent is an example of a fixed home loan. Variable loans do not follow this characteristic, and instead rely on an interest rate which periodically fluctuates during the borrowing term.
I purchased my first home using a fixed home loan. At the time, I prioritised cash flow certainty over interest rate arbitrage, mainly due to personal circumstances. I was still in the early stages of my real estate career, and therefore was uncertain of my future income flows. Therefore, having certainty in mortgage payments gave me comfort that my wife and I could collectively cover payments even if my real estate career faltered.
However as time progressed, my mindset shifted in favour of variable loans. I was doing well in my career and was more secure in trading away certainty for arbitrage. Another important fact was that interest rates have been steadily falling for the past decade. In light of the Reserve Bank’s focus on keeping interest rates low, it didn’t make sense to lock myself into a higher rate.
As it stands, I have a mix of fixed term and variable term loans. The fixed term loans are typically on my smaller loans where I would not benefit greatly from rate arbitrage, whereas the variable loans are on my newer, longer-term loans.
I do not profess to know the optimal balance between these two loan types, as it largely depends on individual circumstances and prevailing market conditions. However to me, what is more important than balance is to understand how each loan works towards your personal investment goals.
Let’s start with fixed term loans. Aside from the cash flow certainty, a fixed term loan typically offers a lower initial rate than variable loans (depending on loan term). Fixed loans also serve as shields for rising interest rates. However, this is a practically negligible benefit as most jurisdictions have moved towards cutting interest rates. However, I did benefit in my early investing years, as Australian interest rates rose from 2002 to 2008.
The biggest drawback of fixed loans is the perceived control imbalance between you and the bank. Once you’ve locked in a rate, it is very difficult to change lenders or re-finance without incurring a sizeable financial penalty. Furthermore, it’s not ideal to be shackled to that rate as you witness the average interest rate declining during your loan term.
Further, if you were to sell your property during the mortgage term, you may be on the hook for discharge fees and other penalties levied by your bank. This is not to say that the same penalties won’t apply on variable loans, however the quantum of penalties for those loan types are typically less than fixed loans.
What is an offset account and why you should seriously consider it!
While there are pros and cons to both loan types, the more important question you should ask yourself is: how much debt are you able and willing to take on? No fancy loan type can save you if you are ill-prepared or lack the discipline needed to manage a mortgage.
If you are ready to take on a mortgage, a fixed loan may be appropriate under the following circumstances:
- You value certainty and predictability over the long-term
- You have a predetermined and unwavering monthly budget, and therefore don’t have much flexibility in paying more or less on your mortgage each month
- While it is near impossible to predict, there is an expectation that mortgage rates may rise over the mortgage period
Alternatively, a variable loan may be suitable in the following instances:
- You wish to aggressively pay down your loan
- You’re willing to sacrifice a higher initial rate in exchange for larger principal payments later in the loan term
- You typically enjoy saving your money, and can therefore benefit from an offset account.
If I were to take on another mortgage this year, it would probably be a variable loan so I can access an offset account. However, if you were to subscribe to the argument that interest rates have bottomed out, a fixed loan may be a more viable option.
I welcome your thoughts on whether one loan type wins out over the other. Also, if you would like me to cover a specific topic within home financing, please let me know in the comments section below. Feel free to also browse through my other posts on home financing!
The content outlined above was written, edited and published by the Lost Realtor. The author has over 20 years or real estate sales and investing experience in the Australian property market. He has held senior positions in Australian building companies, including being the General Manager of the residential sales division of Collier Homes. His qualifications include a Bachelor of Commerce degree and a Graduate Diploma in Building and Construction Law.