Variable rate loans
Variable rate loans mean that the interest rate applied on a loan can change over time. In Australia, variable rate loans are anchored to the RBA cash rate. However, the link to the cash rate has become weaker over time, and lenders have discretion to adjust variable rate loans as they see fit. This has become more common since 2016, where regulatory changes have meant several changes to variable rate loans over time.
Variable rate loans mean you are not certain on what your repayment will be over time. For investors with large portfolios, even small changes in the interest rate will have large consequences on their cash flow.
The upside is the flexibility to move between banks as you see fit (important for investors). The downside is the lack of certainty.
Fixed rate loans
Fixed rate loans are also available in Australia, usually up to a maximum five-year period. This offers investors scope to lock in their interest rate for a period of time. This means more certainty, and a hedge against future changes to the interest rate.
It is common for people to think that banks have more information at hand when setting the price of fixed rate loans. While this is true, the banks don’t set their fixed rate loans with view to changes over time. That is, if the fixed interest rate is lower/higher than your current rate, it doesn’t necessarily mean that the variable rate will move in that direction moving forward.
We commonly hear terms like ‘beat the banks’ when it comes to fixing loans. In our view, the exact price itself is not the only consideration when fixing loans.
One way to make this decision is to consider fixing your interest rate as risk mitigation strategy. For those who do not have the cash flow to sustain changes to interest rates over time, it is important to manage this risk by having a portion of the portfolio on fixed interest rates.
The downside of fixing your interest rate is you lose flexibility to move your loans around. You also need to pay an early repayment fee if you ‘break’ your fixed rate loan early (i.e. you discharge your loan or choose to move it to variable).
If you’re at a point where you know where your investing is heading in the short/medium term (usually in a consolidation phase or when you’re not making further purchases), flexibility may be less important to you and the ‘cost’ of fixing is limited. If you’re in a period where you are making purchases aggressively, it usually makes sense to have the flexibility of variable loans.