Fixed vs floating interest: what's the difference?
Your choice of a fixed or floating interest rate for your home loan can make a huge difference to how much you pay and how fast you pay it. It's one of the most important home loan decisions you'll make!
Let's look at what you need to know about the pros, cons and differences between the two types of interest rate, and which could be right for you.
WHAT IS A FIXED INTEREST RATE?
A fixed interest rate on a loan means you pay the same amount each week, fortnight or month. It stays the same for the whole length of the fixed term you agreed to.
Here’s an example. You take out a loan and agree to a fixed interest rate and a weekly repayment schedule. The first week comes up, and you pay $500. The next week comes up, and you pay $500 again.
This repeats until your fixed rate loan term finishes. If there's still more owing on the loan, you can then re-fix.
Extra info: Every time you make a repayment on a standard principal & interest fixed rate loan, you will pay slightly less in interest and slightly more off your principal (the initial amount you borrowed).
- You’ll always pay the same amount every time, so you know exactly how much to budget for. If you’re worried that interest rates might rise, a fixed rate option means you can lock in your payments and they will not change during the fixed rate period. You can choose how long you fix for (usually up to five years).
- Many lenders compete on their fixed rate interest offers. This means you can negotiate a good deal. At the time of writing, most lenders’ fixed rate offers are also lower than the floating rate.
- Fixed rates are the simple option. You always know your rate and payment for the fixed term.
- If you come into some money and you want to make an extra repayment to your loan, you may be charged to do that. If you want to sell your home or refinance, there may be a ‘break fee’. These extra fees can be quite expensive.
- You can usually only fix your interest rate for up to 5 years. At the end of your fixed term, you’ll have to re-fix your loan or switch to a floating rate. This means you get a new interest rate which might mean a higher payment.
Fixed rate loans are good for people who like consistency in repayments.
WHAT IS A FLOATING INTEREST RATE?
If you have a loan with a floating or variable rate, the interest rate you are charged can change. That means your repayments can change and might be less or might be more.
Here’s an example. You take out a mortgage and agree to a variable interest rate and a weekly repayment schedule. The first week comes up, and you pay $500. A month later, the floating interest rate goes up and your next weekly payment increases to $520. The month after that, the floating rate drops, and your payment decreases to $480.
Your lender will notify you when rates go up but you have to be prepared to have your payments increase. There is also the possibility that the interest rate goes down and your payments can be reduced. The challenge is you have no control over the rate.
- A variable rate loan lets you make extra repayments without penalty. You can also usually make extra repayments without being charged a fee like with a fixed rate.
- If you suddenly want to sell your home, you won’t be charged for breaking a variable rate loan. You can also switch over to a fixed rate without penalty. With a fixed rate loan, you are forced to wait until the end of the term or pay a break fee to swap.
- If interest rates drop, you will benefit by paying less interest on your loan.
- If interest rates rise, you will have to pay more. This may require you to increase your payments which you may not have budgeted for.
- If you want to get the most out of a variable rate loan, you have to be prepared to be affected by the market. This can be hard as there are many economic factors that influence interest rates and even experts in this area can have different opinions.
- Currently, variable rates are higher than most fixed rates offers.
Floating/variable rate loans are great for people who want to take advantage of the potential for reducing interest rates. They’re also good for people who want flexibility to pay down their loan faster or who may have changes in circumstances.
ARE THERE ONLY FIXED AND FLOATING RATES?
Some people choose to put some of their mortgage on a floating rate and some on a fixed rate. This is called a split loan. People do this to pay down on the floating part without being charged early repayment fees, but still have most of their loan consistent through the fixed rate. They get a mixture of the pros and cons from both.
So what’s the best rate for you? There is no single answer to this question! The information above is a good first step, but what is best for you will be depend on your individual circumstances and goals. Seek advice from an advisor or trusted professional before you take the plunge.
If you’re self-employed or a small business owner in New Zealand, getting a loan can be challenging - but not impossible. Avanti Finance Head of Commercial Robin Hopkins explains.