What is a fixed rate home loan?
With this kind of mortgage, you lock in an interest rate for an agreed-upon term — usually up to 5 years. The interest rate you agree to pay remains constant for the fixed rate period, so for that period, your regular repayments will remain exactly the same.
Most major New Zealand banks offer a range of fixes between 6 months and 5 years, with a few banks offering 7 or 10-year fixed home loans. This means your interest rate (and your repayment amount) stay the same regardless of what is happening in the economy. At the end of your fixed term, you can take up a new deal with the bank to re-fix, or switch to a floating rate mortgage.
Fixed interest rates can be beneficial when the official cash rate (and in turn, interest rates) go up because your monthly repayments remain the same, whereas a floating rate home loan will see the repayments increase.
What is a floating rate?
With a floating rate (or variable rate) mortgage, the interest rate you agree to pay can move in line with general economic conditions. As interest rates increase, the terms of your mortgage mean that your interest rate and your repayments may increase too. If the market changes and rates go up, your bank would notify you that the rate you are paying will increase (or decrease if interest rates are reduced).
Floating rates move in line with the Overnight Cash Rate (OCR) set by the Reserve Bank, and with general market conditions. While it’s possible the rate can go up, depending on economic conditions, the interest rates could also go down — which would make the repayment amount cheaper.
A floating rate or variable mortgage does not have a term, and you can generally pay off extra lump sums without penalty. In New Zealand, you generally pay for this flexibility as floating rate mortgage rates are considerably higher than fixed rates.
Let’s do the numbers on fixed vs floating
Let’s say your friend’s floating rate mortgage has a balance of $300,000 with a 30 year term. The floating rate set by her lender at the time of the home loan was 5.5%, meaning her fortnightly repayments would be $786.
- A decrease in the floating rate of 0.25% would decrease her fortnightly payments to $764.
- An increase in the floating rate of 0.25% would increase her fortnightly payments to $808.
Alternatively, a 5-year fixed rate of 5.30% would have a constant fortnightly repayment of $769 for the next 5 years — with no surprises regardless of what the cash rate does.
So while there is an opportunity for your friend to save money if rates happen to drop, there is also a chance that her repayments will increase.
This needs to be considered alongside the certainty you gain from fixed rate loans where you know exactly what you will have to pay regardless of what happens to the economy.
Pros and Cons
Fixed rate mortgage
- Certainty: you know your exact payment obligations for the fixed term. This allows you to budget, as knowing the exact payment amount makes financial planning easier. If you have a fixed income, you can plan for a portion of this to be used for mortgage payments.
- Safeguard: If you think an interest rate is favourable, then you can lock it in for a set period of time.
- Limit: your payments will not increase unexpectedly for the life of the fix.
- Early repayment penalties: this type of home loan does not allow lump sum/early repayments, so you would need to restructure your loan if you wanted to make an extra payment. There is a fee for doing this.
- No potential for lower repayments: if rates decrease, your payments will still remain the same.
Floating Rate mortgage
- Potential for lower repayments: if interest rates decrease, so too do your repayments.
- Flexibility: you can make early or lump sum payments without penalty. If rates do go down, then you might use the money you have left over to make an extra payment. If rates go up and you come into some extra funds, you might make a lump sum payment to reduce the size of your mortgage and the amount of interest paid.
- Risk: repayments might increase if interest rates increase.
- Uncertainty: not knowing your repayment obligations can make planning for the future difficult.
Are there other options?
Some banks offer a capped rate. That is, the interest rate is floating, but there is a ‘cap’ or limit to how much it can go up. This protects you from large rate increases. Typically a provider of these loans would charge a premium for the home loan or have conditions that must be met, like a high equity ratio.
Fixed vs floating summary
If you choose to use a mortgage adviser, they should be able to offer advice about which product will suit your personal circumstances best.
Understand your financial situation
The decision about which is right for you depends on your income and ability to absorb changes to your payments. You should also consider your appetite for uncertainty; are you the type of person that will worry about the possibility of rates going up?
Consider a mix
Finally, you could also consider splitting your home loan and have a portion fixed and a portion floating, thus gaining the best of both worlds. This is particularly useful if you are expecting a lump sum in the near future but are not sure exactly when.
What is a revolving credit mortgage?
A revolving credit mortgage works as an overdraft on an everyday transaction account, except the interest rates are floating mortgage rates.
Can I choose to have a fixed or floating rate with an interest-only mortgage?
Yes. If you choose to have an interest-only mortgage, you still have the flexibility of choosing whether you have a floating or fixed loan.
What is an offset mortgage?
An offset mortgage allows you to accumulate savings to directly reduce the loan balance for interest calculation purposes. For example, your loan balance is $300,000 and you have $100,000 in your offset. You only pay interest on the reduced balance of $200,000.
If you’re looking at an offset mortgage, they are only available with a floating rate home loan.
What is a default interest rate?
The default rate may be charged if you do not make your repayments when they are due. For example, if interest rates drop, but your repayments remain the same because you have a fixed mortgage, the lender can charge you a default interest rate in addition to your regular rate if you fail to make your repayments on time.