Fixed vs floating interest: what's the difference? [VIDEO]
One of the most important parts of choosing a loan is ensuring that the payments are affordable, both now and in the future. A big part of that depends on your interest rate and whether it is fixed or floating, or even a mixture of both. Choosing the right option can make a big difference to how much you end up paying in the long run.
Here is some of what you need to know and consider.
WHAT IS A FIXED INTEREST RATE?
If you have a loan with a fixed interest rate, you will 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.
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 in that you 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 can be quite expensive depending on the market rates at the time.
- 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 be at a higher rate and payment than you have been used to.
Fixed rate loans are good for people who like consistency in repayments. You can ensure this by choosing a fixed rate that typically lasts for one to five years.
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. And 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.
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 reduce the loan term and total amount of interest paid by making extra repayments
- If you suddenly want to sell your home, you won’t be charged for breaking a variable rate loan. If you wanted to switch over to a fixed rate, you can 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.
- Cheaper (sometimes). 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, but still have most of their loan consistent through the fixed rate. In other words, they get a mixture of the pros and cons from both.
So what’s the best rate for you? There is no one 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.
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