Should you consider a split loan?

Interest rates are set to stay low for some time but uncertainty remains over which way they’ll move over the medium to longer term.

Variable rates are popular with borrowers. More than four out of five loans written nationally in February through Mortgage Choice had a variable rate, the broker’s latest data shows.

“In December 2013, fixed rate demand peaked at 33.06%, while today this type of home loan accounts for just 19.56% of all loans written,” Mortgage Choice spokesperson Jessica Darnbrough says.

“While fixed rate pricing has dropped dramatically across the board in recent months, it seems borrowers are more comfortable taking out a variable rate mortgage.”

For people who want some certainty and protection from rate increases but don’t want to miss out completely if rates fall further, split rate loans offer an alternative.

Split rate home loans allow borrowers to fix the interest rate on a portion of the loan and leave the rest variable.

It’s difficult to tell exactly how many people are taking out split loans because most mortgage products offer the option lenders don’t report the figures separately. Anecdotally, split loans do seem to be gaining popularity.

Michelle Hutchison, money expert at comparison website Finder.com.au says it wouldn't be surprising to see more borrowers choosing to split their home loan as there’s increasing uncertainty about the direction of interest rate movements.

“The Finder.com.au Reserve Bank Survey shows mixed results with which direction the cash rate will move this year. Another indicator is that most lenders have not followed every cash rate movement throughout this downward cycle over the past three and a half years,” Hutchison says.

“Borrowers may not know which option is better so hedging your bets and splitting your loan with part fixed and part variable divides the risk.”

The benefit of splitting a home loan is that it combines the features of a fixed and variable rate loan. The variable portion offers flexibility, allowing you to participate in subsequent interest rate cuts, while typically being able to make extra repayments or redraw from the mortgage. The fixed portion is usually more restrictive but does lock in the interest rate shielding you from increases in the required repayments if rates rise.

It’s common to fix 50% of the loan but most lenders will allow you to choose whatever combination of fixed and variable rates you want.

Many lenders will allow borrowers to split rates using their existing mortgage without having to refinance. Check with your lender on their policies.

As with all types of loans, interest rates vary between lenders.

One example is from Homeloans.com.au which is offering a split rate mortgage where up to half of the loan is split with a comparison rate of 4.72% on the variable component and 4.72% on the fixed rate for a three-year term. For a one-year fixed rate component the rate is 4.74% and for five years it’s 4.84%.

Using those rates as an example, let’s say you have a $300,000 loan over 30 years. You fix half of the loan over three years using the mortgage product above and leave the other half on the variable rate.

Initially, the monthly repayment will be $1,560, comprising of $780 for the fixed component and $780 for the variable component (see table below). Since the fixed and variable rates are the same in this example, the cost is the same as for a loan with a 100% variable rate.

If the RBA cuts interest rates by 0.25 percentage points, and the lender passes on the rate cut in full to its variable rate loans, the interest rate on the variable component will drop to 4.47% but the fixed rate will remain at 4.72%. The monthly repayment will drop to $1,537. However, if you had a completely variable rate loan, the monthly repayment would be $22* less, at $1,515.

Similarly, if the RBA lifted rates by 0.25 percentage points and the lender passed on the increase, monthly repayments on the split rate loan would rise to $1,582, while monthly repayments on a loan with 100% variable rate would go up by $23* more to $1,605.

While $20-something a month doesn’t make a huge difference to most budgets, if the economy picks up over the next three years and interest rates rise more dramatically, the saving will become more significant.

Looking back three years ago to April 2012, the official cash rate was 4.25%, a full 2 percentage points above what it is today. It’s possible that over the next three years conditions will improve enough for the official rate to be lifted again back 4.25%.

Assuming lenders passed on the rate rises, the variable rate on the mortgage in the example above would increase to 6.72%, while the fixed rate would of course remain at 4.72%. Monthly repayments in this instance would rise to $1,750. In contrast, the monthly repayments on a mortgage with a 100% variable interest rate would be $1,940. That $190 a month would make a sizeable difference to most budgets.

Monthly repayments on a $300,000 loan over 30 years

Source: Property Observer using Homeloans.com.au split loan and variable rate loan calculators.

*Note: the difference between these figures is due to rounding throughout the example.