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Understanding interest rates

Interest is the cost of borrowing money. You pay interest to a lender as part of your regular loan repayments. Most lenders let you choose a fixed or variable interest rate home loan.

Before you decide whether to buy a property, you should understand how interest rates work and the various types available so you can make an informed decision.

Consider these factors when deciding which interest rate type suits you best:

  • security: if it’s important to know that your repayments won’t increase to an unaffordable level
  • certainty: if you’d prefer to know your interest rate in advance, so you can budget accurately
  • flexibility: if you want to pay off the loan quickly without penalty
  • personal view: if you see interest rates increasing or decreasing in future
  • best value: if you need the lowest interest rate possible.

Read about these types of interest rates:

Fixed interest rate

A fixed interest rate allows you to fix the rate of interest charged on your home loan for a specific period—usually 1–5 years.

Your interest rate doesn’t increase or decrease during this time, even if market interest rates increase or decrease.

Advantages

  • Fixed interest rates protect you from unexpected increases in your repayments, enabling you to budget your repayments accurately.

Disadvantages

  • If variable interest rates decrease during your fixed period, your interest rate doesn’t decrease as well.
  • Some mortgages don’t allow early or lump sum repayments on fixed home loans without penalties. You usually pay fees and charges plus the full interest outstanding if you:
    • pay out your fixed interest rate home loan early (e.g. if you sell your house) before your fixed term expires
    • convert to a variable or other fixed interest rate before your fixed term expires.

Variable interest rate

A variable interest rate increases and decreases throughout the loan term based on market conditions.

Variable interest rates may be higher or lower than fixed term interest rates.

Advantages

  • Your interest rate is comparable to other interest rates in the market at the time. So, if market interest rates decrease, your rate usually decreases as well.
  • When your rate decreases, more of your repayments go to reducing your loan balance. Some lenders automatically reduce your repayments if rates fall, but many don’t.
  • A variable rate can be a good choice if rates are expected to fall or remain stable.
  • You don’t usually pay penalties on lump sum payments or early payouts.

Disadvantages

  • Interest rates may increase at any time, depending on financial market conditions.
  • If interest rates increase, your repayments may increase too. If they don’t increase, consider repaying more because, otherwise, your loan term and number of repayments will increase (because there is more interest to pay off).

Capped rate

With a capped rate loan, the interest rate can’t exceed a set level for a set period. And like variable interest rates, capped rates can decrease in line with market conditions.

Sometimes the capped rate is higher than the starting rate, so the interest rate may increase a little if market rates change before the capped rate is reached.

Sometimes there is a ‘floor’ rate, beyond which interest rates can’t decrease.

Advantages

  • Like fixed rates, capped rates protect you from large, unexpected increases in your repayments. This enables you to budget your loan repayments accurately.
  • Like variable rates, if market interest rates decrease, capped rates usually decrease. More of your monthly repayments then go to reducing your loan balance.

Disadvantages

  • You may pay an extra fee if you pay out your capped interest rate loan or convert it to a variable or a fixed interest rate before the capped term expires.
  • Some mortgages may not allow early or lump sum repayments on capped rate home loans without penalties.
  • The capped rate is usually slightly higher than the standard rate for that period.

Introductory rate

Introductory rates, also called ‘honeymoon’ or ‘discounted’ rates, offer a low interest rate fixed for a short period—usually 6–12 months – for new borrowers.

Advantages

  • You can start a home loan with the lowest possible mortgage repayment, enabling you to adjust to the extra costs of home ownership.

Disadvantages

  • Your repayments may increase dramatically when the introductory period ends, particularly if market interest rates have increased during that time. You must budget carefully for this increase and not take on extra debt during this period.
  • You may have to remain on a variable interest rate for a set time after the introductory period, so you may not be able to move to a fixed interest rate.

Split or combination rate

Loans with part-variable and part-fixed interest rates are called ‘split’ or ‘combination’ loans. They let you pay a fixed interest rate on one portion of the loan and a variable interest rate on the remaining portion.

Advantages

  • Split loans offer the benefits of both fixed and variable rate loans:
    • If interest rates increase, the interest rate on the fixed portion doesn’t change.
    • If interest rates decrease, the interest rate on the variable portion decreases.
  • You can usually make extra repayments and pay out the variable portion of your loan without penalties.

Disadvantages

  • Your repayments can still increase in line with market conditions.
  • You don’t get the full benefit of interest rate reductions, as the interest rate on the fixed portion remains steady.
  • Penalties usually apply if you pay out the fixed portion of your loan early.

Comparison rate

Comparison rates help consumers see the true cost of a loan and compare rates between lenders.

A comparison rate includes the interest rate and fees and charges relating to a loan, reduced to a single percentage.

Comparison rate calculations consider the:

  • amount of the loan
  • term of the loan
  • repayment frequency
  • interest rate
  • fees and charges connected with the loan.

Note: The fees and charges in the comparison rate don’t include:

  • government charges, e.g. stamp duty or mortgage registration fees
  • fees and charges that may or may not be charged because they depend on an event that may or may not occur, e.g. early repayment
  • fees and charges that can’t be established when the comparison rate is provided.