Variable, fixed and interest only loans
Loans may also be classified based on their interest rates. There are three main types:
Variable loan
Fixed loan
Interest only loan
Variable loan
A variable interest rate loan is when the interest rate of the loan can fluctuate up or down throughout the period of the loan. Lenders may increase or decrease the interest rate of the loan at any time. The interest rate may change in response to decisions made by the Reserve Bank of Australia (RBO), as well as other factors.
Pros and cons
The pros include:
You have the ability to make additional repayments, allowing you to pay off the loan faster without incurring interest rate break costs.
Some variable rate loans also offer features like offset accounts or redraw facilities that work to reduce the loan balance you pay interest on, while still allowing you to access surplus funds.
Interest rates have the potential to decrease.
Variable loans rarely have exit fees.
It is easier to refinance. If you find a better deal elsewhere, it may be easier to switch to a different lender or home loan product if you’re on a variable rate, without attracting break costs.
The cons include:
Rates have the potential to increase.
Sometimes, variable loans have less features in comparison to other loans.
It may be difficult to plan and budget financially, as your repayment amounts can rise and fall over the course of your loan.
Fixed loan
A fixed loan is a type of loan where the interest rate is set at a fixed rate which remains the same for the entire term of the loan. This means that the borrower’s monthly payments will be the same amount for the entire loan period, regardless of changes in interest rates.
Pros and cons
The pros include:
You can budget and plan ahead with confidence over the life of your fixed loan period.
They can be highly affordable when rates rise.
Repayments don’t change during the fixed rate term.
Some lenders may offer an introductory fixed loan offer which can be more appealing for some.
The cons are:
Loan exit fees can be high if you decide to exit the loan before the end of its term.
Many fixed loans do not allow the borrower to make extra repayments without incurring a fee.
Most fixed loans do not have a redraw facility available, meaning you can’t withdraw funds from the loan.
If the fixed period expires when rates have increased, borrowers may find it harder to meet the repayments.
If the variable rates decrease, you will still be paying the same amount as initially agreed upon.
Interest only loan
An interest only loan is when a borrower requests to only pay off the interest of the loan to lower their repayment costs. This means your loan balance won’t reduce during the interest-only period, since you are not making any principal repayments.
Pros and cons
The pros include:
Your repayments are initially less, allowing you to set up your finances and have more cash on hand for emergency situations.
You can make extra repayments.
The cons include:
Interest only terms are typically only up to 5 years.
Once the interest only term ends, the loan reverts to a principal and interest loan, and your repayments will increase.
If you do not intend to make additional payments, then you are not paying anything off the principal of the loan. Thus, interest remains high and is not reduced over the loan term.