Understand the difference between mortgage types before deciding on a plan
Home buyers deciding between fixed or variable interest rates need to clearly understand the two options before choosing, says Leonard Kondowe, national administration hub manager for Rawson Finance.
Variable rates are linked to the prime lending rate whereas fixed interest rates remain the same, regardless of the Reserve Bank’s repo rate.
Variable rate bonds are the most common, he says.
“They’re called variable because the interest rate the bank quotes you is linked to the prime lending rate. That means if prime goes up your repayments go up, and if prime goes down your repayments go down too.”
A typical example of a mortgage bond with a variable rate would be granted at prime plus or prime minus, depending on the applicant’s overall credit score.
Kondowe says a variable interest rate minimises the risk for lenders, which means they can usually offer applicants a more competitive deal. This is why variable interest rates are often as much as 2% lower than fixed rate equivalents, if not more.
A fixed-rate bond is not linked to prime and means that the rate the bank quotes you is what you’ll pay, regardless of what happens to the Reserve Bank’s repo rate.
“A fixed-rate bond is quoted as a specific percentage – say 12%. If prime goes up during the term of your fixed rate, it makes no difference – you’ll still pay exactly 12% interest on your loan. That can be very reassuring for homeowners who are at the upper limit of their affordability and are expecting prime rate to be revised upwards.”
Unfortunately, since fixed rates are typically around 2% or higher than variable rates to start off with, bondholders would need the prime interest rate to increase by more than 2% very early on in their fixed rate period to benefit financially.
But it is rare for interest rates to increase more than 1% in a year.
Kondowe says another downside to fixed rates is that they are only offered for relatively short terms – a maximum of 60 months, as opposed to a bond’s total term of 20 or 30 years. At the end of this period, you’ll either revert to your originally quoted variable rate or have to renegotiate with your bank for a new fixed rate offer.