Fixed Rate Loans Variable Rate

Comparison rates

A lot of borrowers see a headline rate and think wow!  That’s much better than my current loan.

The issue is that these headline rates can be misleading.  Things like

  • account keeping fees
  • annual fees
  • introductory rates
  • fixed rates that then convert to a horrible variable rate after the fixed term

can all be used to hide the real cost of a loan.

As an example, on a $250,000 loan, a typical $395 annual fee is equivalent equates to a rate increase of 0.158% (or that amazing 2.5% becomes 2.658%).  Still a good rate, but not exactly what was offered!

A comparison rate translates these types of things into the equivalent value, so it gives you a better ability to compare.  The comparison rate is calculated on a $150,000 loan over a 25 year term.

Comparison rates on loans are supposed to help you compare different types of loans, so that you get an overall picture, and are designed to take into account these types of things.  So, a loan that says interest rate 2.5%, but comparison rate 3.2% is telling you something – you need to look at the fine print to see what else you are paying over the life of the loan.

But comparison rates aren’t perfect.  Comparison rates are ONLY valid for the specific “scenario”, so they aren’t a like for like comparison.  A borrower with a larger loan, or a shorter term would typically see less movement from the headline rate.  Still, a much larger comparison rate should be a flag that says “Borrower beware!”.

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Fixed Rate Loans Variable Rate

Fixed vs Variable

What are the pros and cons of using these two loan types? It seems to me that people are easily sucked into the lower rate provided by the Fixed rate loans right now. So, what is the catch?

Generally, Fixed rate loans have a limit on how much extra you can pay, so if you are able to make extra repayments, or you want to make use of an offset account, then you would need to read the contract details to see whether you can do these things. There may be a limit on how much extra you can repay, or there may be a penalty if you pay too much or too quickly.

The big benefit of a Fixed rate is if you want certainty of how much you will need to pay each month. From a budgetting perspective, this can be useful.

Variable rate loans often allow you to pay extra, or to use an offset account (to “offset” your savings to lower the loan principal for the purpose of calculating interest on the loan). Quite often the interest saved by using either of these two options means that the super low rate of the Fixed loan does not look that super anymore.