Fixed rate vs variable rate home loans: Which are better?

Taking up a home loan is a life-changing decision with financial impacts which commonly last for decades. Because of the large amount of money that is often involved in a home loan, the interest rate is usually the greatest consideration for home loan borrowers, and rightly so.

When it comes to home loan interest rates, there are generally two major categories: fixed rates and variable rates.

The former remains fixed throughout the loan period, whilst the latter fluctuates with market conditions.

For most home loan borrowers, making a choice between the two is daunting. In fact, many don’t even bother making the choice and allow the banks to do so on their behalf.

But for those who wish to make a decision on your own judgement, start off by understanding the main difference between fixed rates and variable rates.

The Difference between fixed rate and variable rate home loans

As mentioned, a fixed rate home loan features the same interest rate over the entire loan period. Say you apply for one at a rate of 5% p.a., your outstanding loan amount will be charged at an interest of 5% p.a. until the day you pay off your entire loan. There are absolutely no fluctuations in interest rate.

In Malaysia, variable rate home loans, meanwhile, are commonly pegged to the Base Lending Rate (“BLR”) as recommended by Bank Negara.

As an example: say you hold a variable rate home loan offering an interest rate of -2.4%; based on the current BLR of 6.6%, your actual home loan interest rate would be 6.6% – 2.4% = 4.2% p.a..

However, if the BLR rises to 7%, your interest rate too would increase to 7% – 2.4% = 4.6% p.a.. Similarly, if the BLR decreases to 6%, your interest rate would lower to 6% – 2.4% = 3.6% p.a..

Interest rates for fixed rate home loans are usually higher than those of variable rate home loans, to consider possible rises of the BLR in the future.

At present, most home loan products offered by banks in Malaysia tend to be variable rate. Fixed rate home loans are more common among “non-bank” financial institutions such as AIA and ING, though they are also available (though not as aggressively marketed) in certain banks.

Financially, which is the better option?
 
Many people instinctively opt for variable rate over fixed rate loans, since the offered interest rate of the latter is almost always higher than the former.  For example, a fixed rate home loan by AIA currently has an interest rate of 4.85% p.a., while a variable rate home loan offered by some Malaysian banks are going at 4.2% p.a..  The mere difference of 0.65% for a principle loan amount of RM500,000 is a whopping RM3,250 in total interest repayments for the first year!

However, should the BLR rise during the loan period, the picture could change in dramatic fashion. Say the BLR climbs up to the 8% territory (which actually happened in 1999), a person on variable rate home loan with an interest rate of -2.4% would be paying a towering interest of 5.6% p.a..  In such a scenario, the person who opted for a fixed rate home loan of 4.85% p.a. would be paying RM3,750 less interest every year.

Because there is no way to accurately predict the movement of BLR, there is also no sure-fire way to ascertain if fixed rate or variable rate is financially the better option.  Theoretically, both choices have the potential of saving you money or making you pay higher cost; and it is up to you to balance the potential benefit and potential risk involved.

The following is the historical trend of BLR in Malaysia (source: www.blr.my):

1990	1991	1992	1993	1994	1995	1996	1997	1998	1999	2000
7%	7.5%	9%	9.5%	8.25%	6.6%	8.5%	9.25%	10.5%	8%	6.75%
2001	2002	2003	2004	2005	2006	2007	2008	2009	2010	2011
6.75%	6.5%	6.5%	6%	6%	6%	6.75%	6.75%	5.55%	5.8 – 6.3%	6.6%

But Wait, There Are Other Considerations

The difference in interest rates aside, there are a few other factors one should take into consideration.

Firstly, there is the predictability. When you opt for a fixed rate, you’re assured of consistent monthly payments for the entire loan period, which allows you to engage in long-term financial planning and to set up a monthly personal budget with 100% certainty.

Predictability is, in fact, far more important than many would think. This is especially true for fixed income households living on shoestring budgets, where a sudden rise in monthly loan repayments could potentially create a drastic financial impact affecting livelihood.

For such demographics, a fixed rate home loan offers a sense of stability that a variable rate home loan would not.

Secondly, there is the matter of convenience. In Malaysia, variable rate home loans generally come with plenty of value-added features such as overdraft and redraw facilities – which may come in very handy when cash is needed urgently. Fixed rate home loans offered by “non-bank” institutions commonly do not have such features.

Thirdly, there is the insurance. In Malaysia, fixed rate home loans offered by “non-bank” institutions usually require you to take up Mortgage Reducing Term Assurance (“MRTA”) or other kinds of life policy for the full amount of your loan, and for the entire loan period.

Although MRTA is also a requirement for most variable rate home loans offered by banks, they are usually not as stringent with the terms. In many cases, you may negotiate to take up minimal insured amounts and coverage periods, which means you’re likely to incur less cost on MRTA.

But take note that taking up maximum MRTA coverage may not be a bad thing, especially for sole breadwinners who wish to protect their family against any unforeseen circumstances. This is because MRTAs helps settle covered home loan amounts in the event of death or total disablement of the borrowers.

Yet another point to ponder upon is the blurring of the line between a fixed rate and a variable rate home loan.

Nowadays, more banks are coming out with alternative home loan options, which include “hybrid” rates that combine both fixed and variable rates (i.e. usually involving a fixed rate for the first few years before the rate is subjected to adjustments thereafter) as well as “capped” rate home loans, which are essentially variable rate loans that limit the rise of BLR to a cap for a period of time.

And finally, one should consider that the growing popularity of home loan refinancing means home loan borrowers do not necessarily need to stick with their existing home loan packages for the long haul. If switching from fixed rate to variable rates or vice-versa through refinancing helps you get a better deal, it is always a viable move as long as the switch does not involve hefty refinancing fees that eat off whatever savings you’re making from the interest.

by imoney.my

www.iMoney.my compares between the various loans, savings and insurance schemes available in Malaysia.