There are usually three options available to borrowers on paying off their home loan. These are: variable; fixed; or a combination of variable and fixed interest rate home loans. All three options contain advantages and disadvantages. We will look at some of those here.

Variable interest rate home loan

A variable interest rate is an interest rate that changes throughout the term of the loan in line with market interest rates. The main driver of market interest rates in Australia is the Reserve Bank who set the cash rate (in other countries this would be the respective central bank, and the data for this can be found on the web).

If you have a variable interest rate, it’s a good idea to keep an eye on the changing rates set by the Reserve Bank (or the respective Central Bank for your country). This is because—generally speaking—changes to the official cash rate by the Reserve Bank can change the interest rate that a lender gives to you (which in turn may increase or decrease your interest rate). For example, if the Reserve Bank of Australia reduces the cash rate from 6.00% to 5.75%, lenders may then be influenced to change their market interest rates in the same direction, which in this example is down (but this may not always be the case—lenders may keep their interest rates on hold; or worse, increase it even though there is a decrease by the Reserve Bank).

The variable interest rate home loan is considered to have on average, lower starting interest rates compared to fixed interest rate home loans (but not always; so keep an eye on this), as the risk associated with changes to the interest rate is transferred from the lender to the borrower. For example, a borrower with a variable interest rate home loan will wear changes to the interest rate.

When the interest rate rises, you pay more, and when the interest rate goes down, you pay less.

The advantages of variable interest rates are:

• you can usually make extra repayments (and therefore you may be able to pay your loan out faster);
• when an interest rate decreases, you pay less interest, saving you money;
• lenders often offer low introductory variable interest rates;
• you may be able to use redraw facilities;

The disadvantages of variable interest rates are:

• your repayments rise when interest rates rise;
• you may experience a decreased sense of security as expenses may change when interest rates change;

The Honeymoon Loan: A variation of the variable interest rate home loan

A honeymoon loan is a variable interest rate home loan that has a competitive interest rate (usually much lower than the average standard interest rate) that lasts for a specific period of time (such as 1 or 2 years) at the beginning of the home loan.

This lower interest rate period is known as the honeymoon period and after this time (and for the rest of the life of the loan), the interest rate rises back up to a higher rate (sometimes higher than the standard interest rate).

Variable rate changes still apply, they simply apply at a reduced interest rate for a small period of time during that honeymoon period.

A honeymoon loan can seem very appealing; however, since the honeymoon period only lasts for a short time (usually less than 3 years), your loan will default back to a higher rate. If you plan to pay out your home loan over a short period (e.g., five or ten years) a honeymoon loan may be beneficial for you; however, if you plan to pay your loan off over many years (e.g., over 15 years), a honeymoon loan may not be suitable (unless you can negotiate a competitive interest rate once the honeymoon period has finished—check with your lender).

Fixed interest rate home loan

A fixed interest rate home loan is a loan in which the interest rate and repayment amount remain the same for a set period during a loan. When the set fixed period ends the interest rate changes to a variable interest rate or it can be fixed again if the borrower chooses.

A fixed interest rate loan is considered to have on average a higher starting interest rate compared to variable interest rate loans (but not always), as the risk associated with changes to the interest rate remains with the lender. For example, a borrower with a fixed interest rate will not be affected by changes to the variable interest rate.

The advantages of fixed interest rates are:

• a sense of security and certainty as you know your repayment amount is stable for the fixed period;
• it allows you to budget as you know how much and when to make repayments towards your home loan;
• should interest rates rise your repayments would remain the same for the set fixed period;

The disadvantages of fixed interest rates are:

• you may not be able to make extra repayments so you may not be able to pay your loan off faster;
• if you want to make extra repayments, they are generally met with additional fees;
• should interest rates fall during the set fixed period your interest rate and repayments will remain the same at the higher interest rate;
• a fixed interest rate loan generally is not as flexible as a variable loan;

Combination of variable and fixed interest rate home loan

Lenders may also offer loan products where the interest rate is split between variable and fixed interest rates for a given period. This means that one portion of your loan would be fixed, while the other portion would be influenced by variable interest rate changes.

One advantage of a combined variable and fixed interest rate home loan is:

• your loan is always partially suited to the economic situation such as changes to the interest rate;

One disadvantage of a combined variable and fixed interest rate home loan is:

• you may not receive the full benefits of a variable or fixed loan;

Which loan did we choose?

Our main objective for our given situation was that we wanted to make extra repayments on our home loan (without being penalised by fees), and we wanted redraw facilities available to us. At the time we were searching for our home loan, a variable interest rate loan was the only means for achieving this so that’s what we chose. At the time, variable interest rates were also lower than fixed. Should interest rates fall, we would benefit, and should they rise, we would wear the costs associated.

We also opted for a honeymoon loan as we were advised by our lender that if we were to make good repayments over the initial ‘honeymoon’ period, we would be able to negotiate a better loan thereafter (check if your lender would do the same before deciding to sign up for one). We were planning to make good repayments so negotiating again during the end of the honeymoon period was ideal for us. At the end of the honeymoon period we were able to negotiate a comparable loan again.

Your situation may be different and the market may by different. For example, there have been times when fixed rates have been lower than variable interest rates. Check the market, analyse your situation and choose which option suits you the most. A combination of fixed and variable may also be suitable, or simply fixed may be suitable. Whatever loan option works best in your situation works best for you. Try to choose the option that benefits you the most.

And when it does come to buy your property, there is one hidden surprise that may be in store for you. Find out what this surprise is in the next blog post.