Are Fixed Rate Home Loans Actually Risky?

One of the first questions you will have to answer when you are in the market for a home loan is whether you want a fixed or a variable interest rate. There are different types of home loan interest rates because there are different types of borrowers, and to help you work out whether you are a borrower who is suited to a fixed rate loan, learn more about them now.

What is a fixed interest rate home loan?

A fixed interest rate home loan offers a fixed interest rate for a set term, which means your repayments will stay at the same amount each month, throughout that term. However, the fixed interest rate you receive is not simply the current standard variable rate locked in. Instead, your lender has set their fixed interest rate, based on what they think official interest rates will be doing over the fixed term.

For example, if the current standard variable rate is 7% and a lender expects a number of interest rate rises in the near future, they may set their five year fixed interest rate at 8.5%. This means that at the start of the fixed term you will be paying more each month, but if interest rates jump ahead to 10% within three years for example, then you will be saving money.

Risky Features of a Fixed Rate Home Loan

While there can be a benefit in having your interest rate and repayments fixed for a period of time, before choosing a fixed rate home loan you need to be aware of the risks of this type of loan, as some can be very expensive. For example, if you choose to sell your home or you want to refinance your home loan to a different loan or lender during the fixed rate term, you can be facing tens of thousands of dollars in break costs.

A fixed rate home loan is an agreement between you and your lender – the lender is agreeing to give you a fixed rate, and you are agreeing to the fixed rate term. Where a fixed interest rate can end up being lower than a standard variable rate, the lender is still able to offer you the fixed rate as they plan on recouping their costs over the term of your loan. However, if you break the fixed rate home loan contract then you can pay a range of exit fees.

The amount you will pay in break costs varies between lenders, but is often calculated according to:

• The time remaining in your fixed rate period.
• The remaining loan amount.
• The difference between the fixed rate and the current fixed rates offered by the lender.
• The official interest rates as break costs will usually rise and interest rates fall to discourage mass exodus.

Usually exiting your loan during a fixed rate term is only worthwhile when interest rates have dropped substantially, and the savings you make from a more suitable loan will outweigh the break costs within 18 months.

With a fixed interest rate home loan you’ll also often receive fewer loan features. For example, you won’t usually be able to make additional repayments, or redraw those repayments during a fixed rate term, and if you are able, the amounts will be limited, or attract fees.

Since fixed rate home loans can cost you more if interest rates drop during your fixed term, variable rate home loans usually cost you less in interest charges in the long term. Most people will take out fixed rate home loans in response to interest rate rises, however, to really benefit from a fixed rate, you need to fix before rates have begun to rise.

Regardless of when you fix your interest rate, you will find that in the past variable interest rates have spent the majority of their time at a rate lower than their fixed counterparts and as a result, variable interest rates usually result in a cheaper home loan product.

At the same time, no one can really predict where interest rates will be going, but every lender’s fixed and variable rates are set by the professional money markets. Each lender has their own team of experts to determine where rates are likely to go, so in most cases you can’t be more informed than the banks themselves, and they are not going to set fixed rates which lose them money.

Who is suited to a fixed rate home loan?

There are instances where the risks of a fixed rate home loan are diminished, and you can beat the banks at their own game. For example, borrowers who choose fixed rate home loans look at them as a type of insurance policy – while you know it is unlikely you’ll be hit by a bus tomorrow and be unable to work, you’re willing to pay for that life insurance policy for peace of mind for you and your family.

The case of fixed interest rates can be the same, especially for borrowers who are on tight budgets, or need certainty in their lives. Even though rates may not rise above their fixed rate, these borrowers are secure in their monthly repayments being exactly the same, and easily budgeted for in the medium term.

Alban Smith is a personal finance writer at Home Loan Finder, a home loan comparison website.