Loan Types Explained

Whether you're a first home buyer taking your initial steps into property ownership or an investor building your portfolio, this comprehensive guide will help you understand the main loan types explained in simple terms.

The type of home loan you choose can significantly impact your monthly repayments, the total interest you'll pay over the loan term, and your financial flexibility. By understanding each option's features, benefits, and potential drawbacks, you'll be better equipped to select a loan that suits your unique situation and long-term objectives.

Fixed Rate Loans

A fixed rate loan locks in your interest rate for a predetermined period, typically between one to five years. During this time, your interest rate and principal and interest repayments remain the same, regardless of what happens to market interest rates.

Who Fixed Rate Loans Suit Best

Fixed rate loans are ideal for borrowers who value certainty and want to budget with confidence. They're particularly suitable for:

• First home buyers who want predictable repayments while adjusting to homeownership costs
• Families with tight budgets who need consistent monthly expenses
• Borrowers who believe interest rates are likely to rise in the near future
• People who prefer the peace of mind that comes with knowing exactly what they'll pay

Pros of Fixed Rate Loans

• Payment certainty: Your repayments won't change during the fixed period, making budgeting easier
• Protection from rate rises: You're shielded from interest rate increases that could affect variable loans
• Financial planning: Easier to plan major purchases or financial decisions with predictable loan costs
• Stress reduction: No need to worry about market fluctuations affecting your mortgage

Cons of Fixed Rate Loans

• Missing out on rate cuts: If interest rates fall, you won't benefit from lower repayments
• Limited flexibility: Often come with restrictions on extra repayments or accessing redraw facilities
• Break costs: Switching loans during the fixed period may incur expensive break fees
• Higher initial rates: Fixed rates are sometimes higher than current variable rates

Variable Rate Loans

Variable rate loans have interest rates that can fluctuate based on market conditions and your lender's decisions. When rates change, your repayments will increase or decrease accordingly.

Who Variable Rate Loans Suit Best

Variable rate loans work well for borrowers who:

• Want the flexibility to make extra repayments without restrictions
• Are comfortable with some uncertainty in their repayment amounts
• Believe interest rates are likely to fall or remain stable
• Want access to features like offset accounts and redraw facilities
• May need to access equity in their property for future investments

Pros of Variable Rate Loans

• Benefit from rate cuts: When interest rates fall, your repayments decrease automatically
• Greater flexibility: Usually offer unlimited extra repayments and redraw facilities
• Feature-rich: Often come with offset accounts, redraw options, and online banking tools
• No break costs: Easier to refinance or pay off early without penalty
• Competitive rates: Often lower than fixed rates initially

Cons of Variable Rate Loans

• Payment uncertainty: Your repayments can increase when interest rates rise
• Budgeting challenges: Harder to predict exact monthly expenses
• Market risk: Vulnerable to economic conditions and Reserve Bank decisions
• Potential for significant increases: Rate rises can substantially impact your budget

Split Loans

A split loan combines both fixed and variable rate components, allowing you to divide your loan amount between the two rate types. For example, you might fix 60% of your loan and keep 40% variable, or choose any split that suits your needs.

Who Split Loans Suit Best

Split loans are perfect for borrowers who want:

• The security of fixed repayments combined with variable loan flexibility
• To hedge their bets on future interest rate movements
• Access to loan features while maintaining some payment certainty
• A middle-ground approach to risk management

Pros of Split Loans

• Balanced approach: Combines the benefits of both fixed and variable loans
• Partial protection: Some protection from rate rises while still benefiting from potential cuts
• Feature access: Variable portion typically retains offset and redraw facilities
• Customisable: You can choose the percentage split that matches your risk tolerance
• Reduced regret: Less likely to feel you've made the "wrong" choice if rates move unexpectedly

Cons of Split Loans

• Complexity: More complicated to manage and understand than single-rate loans
• Partial exposure: Still vulnerable to rate increases on the variable portion
• Administrative burden: May involve separate accounts and statements for each portion
• Compromise solution: Doesn't maximise the benefits of either fixed or variable loans

Interest-Only Loans

Interest-only loans allow you to pay only the interest portion of your loan for a specified period, typically one to five years. During this time, you don't pay down the principal (loan amount), so your loan balance remains the same.

Who Interest-Only Loans Suit Best

Interest-only loans are primarily designed for:

• Property investors who want to maximise tax deductions and cash flow
• Borrowers expecting significant income increases in the near future
• People building new homes who need lower repayments during construction
• Investors planning to sell the property before the interest-only period ends

Pros of Interest-Only Loans

• Lower initial repayments: Significantly reduced monthly payments during the interest-only period
• Tax benefits: For investors, interest payments are typically tax-deductible
• Cash flow improvement: Frees up money for other investments or expenses
• Flexibility: Can help during temporary financial stress or career transitions

Cons of Interest-Only Loans

• No equity building: You're not paying down the loan principal during the interest-only period
• Higher long-term costs: Total interest paid over the loan term is typically much higher
• Payment shock: When the interest-only period ends, repayments can increase dramatically
• Reduced borrowing power: Lenders assess your ability to make principal and interest payments
• Investment risk: Property values may not increase enough to offset the lack of principal repayments

Choosing the Right Loan Type for Your Situation

When deciding between these loan types explained above, consider several key factors:

Your financial situation: Assess your income stability, budget flexibility, and risk tolerance. If you have a stable income and prefer certainty, a fixed rate loan might suit you. If you're comfortable with some uncertainty and want flexibility, consider a variable rate loan.

Your property goals: First home buyers often benefit from the certainty of fixed rates, while investors might prefer variable loans for their flexibility and features. If you're building a property portfolio, interest-only loans might provide short-term cash flow benefits.

Market conditions: Consider current interest rate trends and economic forecasts. If rates are low and expected to rise, fixing might be wise. If rates are high and may fall, a variable loan could save you money.

Personal preferences: Some people sleep better with fixed repayments, while others prefer the potential savings and flexibility of variable loans. Split loans offer a compromise for those who can't decide.

Loan features: Consider which features matter most to you. Do you want an offset account? Do you plan to make extra repayments? Variable loans typically offer more features, while fixed loans may have restrictions.

Making Your Decision

Remember that there's no universally "best" loan type – the right choice depends entirely on your individual circumstances and goals. Many borrowers benefit from speaking with a mortgage broker or financial adviser who can assess their situation and explain how different loan types might work for them.

It's also worth noting that you're not locked into your initial choice forever. Many borrowers refinance or change loan types as their circumstances evolve. The key is choosing a loan that works well for your current situation while keeping your future options open.