How to choose between three-year and five-year fixed loans

Choosing between a three-year or five-year fixed-rate home loan is an important decision. Fixed-interest loans are great for your security, allowing you to lock in a predictable home loan repayment amount for the years ahead. The drawback is inflexibility. If you want to sell, renovate or make additional repayments in the near future, a fixed-interest loan may not be the best option.

Below are the considerations for choosing a fixed interest rate loan:

1. How long do you expect to hold the property?

Homeowners seem to be lulled into a false sense of permanence with bricks and mortar. While homes and units are there for the long-term, your financial commitment to it need not be. According to finance expert Noel Whittaker, “the average house changes hands every seven years and often people’s circumstances change and they are forced to change and incur exit costs.”

So, if you lock in a five-year fixed home loan three years into your homeownership, on average, you may sell it before. This can be an extremely costly way to handle home ownership. The table below highlights an example of early repayments costs. The below is an example of the early repayment adjustment costs alone, before break fees are taken into account:

Fixed-interest loan basic early repayment adjustment example:

For the above example, this borrower has repaid their loan on the fourth year of a five-year fixed home loan. There may have been reasons that have forced the borrower’s hand, such as to repay debts from business failure or to refinance for a crucial structural renovation. In this example, the loan was broken one year early on a five-year fixed loan at an early repayment cost of just over $9,000. This is a significant cost. If your sole purpose was to finance a renovation, you’ve just lost the funds equivalent to a nice new kitchen.

2. Do you need to renovate within this period?

Even something as simple as obtaining finance for a renovation is easier when you’re on a variable-rate loan. Variable construction and line of credit loans are the main financing tools for a renovation. So, if you’re planning to renovate, fixing the interest rate may not be the option.

3. Are you going to make significant additional repayments?

Not many fixed loans allow extra repayments. Lenders that do tend to only offer limited additional repayments at best. Also, you can’t get a 100% offset account on a fixed loan. This is great for offsetting interest charged to the loan — so the ability to pay off your loan early and reduce interest are severely limited on a fixed interest loan.

4. How to choose between three or five year loans?

Of the two ways to choose, one is a constraint, and one is an opportunity.

Firstly, the constraint is the length of time that you can bear the inflexibility of the fixed-interest period. If fixing your interest rate for five years suits your situation, all the better. But if you are thinking of refinancing for a renovation in three years or even upgrading to nicer place, then a three-year fixed period is probably the longest period you should commit to.

This then leads to the second decision. If you’ve decided that you’re staying put for five years or more without renovation, then you have the enviable position of choosing based on interest rate and not interest rate speculation.

At the time of writing, interest rates for three-year fixed loans were lower in terms of headline interest rates. If you were going on that factor alone, three-year interest rates would be the go. But, for the security of fixed interest rates for an extra two years, 0.56% p.a. may not be (time will tell — variable interest rates could also drop) isn’t too much to pay considering historical home lending rates. The average standard variable home loan rate was above 8% p.a. in 2008 (CBA).

Why lock-in?
Fixed interest rates can be a useful option for borrowers who desire security and have a strict budget as to the rise in interest rates that they can afford. A rule of thumb is to budget for interest rates at 2% above the current rate if you’re on a variable home loan. But, if you don’t want to budget for that scenario, a fixed loan is the way to go.

When is the best time to fix?

When fixed interest rates are lower than variable rates. Or while variable rates are likely to rise.

Tips for fixed rate loans:
- check which variable interest rate the loan reverts to

- if you want a bit more flexibility, consider a split rate home loan.

Latest rates for 3 year fixed loans:

Latest rates for 5 year fixed loans:

*A comparison rate includes both the interest rate and the fees and charges relating to a loan, combined into a single percentage figure

Adrian Barclay is a personal finance expert from HomeLoanFinder.com.au.