Fixed vs. floating rates – which is best for you?

If you’re on a tight budget and like the security of knowing how much you will pay each month, a fixed rate may suit you better. But if you have a fluctuating income, or would like to pay lump sums without being penalised, then a mix of fixed and floating might be preferable.

The level of fixed and floating rates is driven by the market and the types of rates offering the lowest interest does vary. Recently fixed rates have been lower than floating.

Fixed interest rate
With a fixed rate loan, the interest you pay is fixed for a period – usually between six months and five years. At the end of the period, a fixed interest loan automatically moves to a floating rate unless you negotiate another fixed term.

There are several advantages of a fixed rate loan:
- You know exactly how much each repayment will be over the term;
- Fixed rates are currently lower than floating rates, as lenders compete with fixed rate “specials”. A one percentage point difference in interest rates can save you thousands of dollars over just a year or two;
- You can “lock in” lower rates if market interest rates are rising however the flip side is that you lock in higher costs if they are falling.

The disadvantage of a fixed rate loan is that you will often be penalised for lifting repayments or making lump sum payments. And if you take a longer term, there is a risk floating rates may drop below your fixed rate. Capped rates can overcome this issue because with capped rates the interest rate cannot rise above the “cap”, but will drop if floating rates fall below the capped rate.

Floating interest rate
With a floating rate, lenders lift or lower the interest rate as interest rates in the wider market change. This means your repayments may fluctuate over time.

The main advantage with a floating rate is that you can lift your repayments or lump sum repayments without penalty. It can also be easier to consolidate other debt into floating rate loans than fixed rate loans.

The disadvantages of floating interest rate loans include:
- Floating interest rates are currently higher than fixed rates;
- When rates go up, the repayments also go up, squeezing your budget.

A mix of both
It is possible to split a loan between fixed and floating rates. This lets you make extra repayments without being penalised on the floating rate portion, while you may get lower rates on the fixed portion.

So which one?
Which interest rate option best suits you depends on both your circumstances and on current financial markets. If you’re someone with a fixed budget who likes stability, you may decide a fixed interest rate is better for you. Another person might decide a mix of fixed and floating rates best suits them because it allows them to plan while still having the freedom to pay lump sums without being penalised. On the other hand, during a period of falling rates and if rates are at a relatively low, stable level, the floating rate option may be better.

No matter which option you choose, it’s important you do your homework first. Take the time to read up on the ‘ins and outs’ of mortgages, shop around to find the best rates, and if you’re inexperienced or confused, seek advice from an experienced expert.

To learn more about mortgages visit www.sorted.org.nz, New Zealand’s independent personal finance website.