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06
Nov 18

The Different Types of Interest Rates.

by Lachlan Hayes
Interest blog covers

Where does the confusion begin? Do you raise one eyebrow when terms like ‘fixed’, ‘compound’ or ‘variable’ start getting thrown at you from all angles? While most of us are aware that different banks offer different interest rates for their products, what some people aren’t aware of is that there are different types of interest rates, each suitable for different purposes and customers. With so many confusing aspects that need to be considered when selecting a loan, it can quickly become a difficult process, so to help you cut through the smoke and mirrors, we’ve explained the common types of interest rates as well as what we understand to be their pros and cons.

Fixed Interest Rates (if you like stability)

A fixed rate, as the name suggests, refers to the interest rate remaining the same for a defined period of time, and won’t fluctuate with the market. Usually, this period is between 1 and 7 years and serves as a great way to protect yourself from an increase in market interest rates. Fixed rate loans are best suited to the budgeters of the world, as having a fixed interest rate means that your repayments will remain consistent from week to week, making it easier to budget.

Fixed interest rates can also be a huge advantage when interest rates are low because you can lock in that low rate. This will mean smaller repayments for longer, however, be careful when signing the dotted line as the costs to exit the loan are often much higher than other non-fixed options.

What’s the idea behind the fixed rate? The bank wants to lock you in so if you are choosing a fixed rate home loan, for example, it’s recommended you plan to own the home (and mortgage) for the entire fixed period, meaning that if we sell, closing your mortgage could be very costly. In most cases, fixed rates are typically higher than variable rates as banks need to protect themselves if market rates suddenly increase, while your repayments remain the same. Meanwhile, the banks cost to have you as a customer would increase – why is this? That’s a conversation for another day.

So, where would you find a fixed rate loan? Fixed rate loans are most commonly attached to the usual consumer lending products - personal loans, car loans and home loans. Given that vehicle and personal loans take between three and seven years to repay, the rate will usually remain fixed for the life of the loan. Fixed rate home loans, on the other hand, are a different kettle of fish. Here, you will lock in a rate for up to five years, then after the fixed period is over, you will have the option to shift to a new rate.

Variable Interest Rates (move with the markets)

Variable rates, unlike fixed rates, will move with rates in the market. These market rates are impacted by the current economic climate and also the banks access to cash (after all, the money they lend to could be someone else's savings). If the market rates increase, your rate will usually follow (and vice-versa). This means that over the course of your loan your repayments will go up and down depending on what is happening in the market.

Typically, variable interest rate loans will come with more features such as offset accounts and fewer fees, however, it can be harder to budget when your repayments are constantly changing. Variable rate loans are often considered the better choice for most Aussies as the initial rate is typically lower than a similar fixed rate product, however, be careful as they have been known to climb throughout the life if your loan. Here’s what we mean:
 
Variable vs Fixed

 
Variable rates aren’t always available on personal loans, yet their pairing with home loans is far more common. As you may have guessed, variable rates are most commonly attached to home loans due to the reason that most customers want the flexibility of being able to have lower rates when market conditions are good.

Split (Variable & Fixed) Interest Rates

At times, having your entire home loan under a fixed or variable rate explicitly is not the most suitable option. Split home loans allow you to have a portion of the loan at a fixed rate and the other part to be at a variable rate. For many, this provides you with the ‘best of both worlds’ where you will have constant stability from rising rates through the fixed rate and also gain benefits from rate cuts with the variable rates.

Simple Interest

Simple interest is one of the most straight-forward ways to calculate interest and put simply (sorry, we had to), the amount of interest you pay is just the percentage of the initial loan that the interest rate is.

For example on a $1,000 loan with a 5% interest rate, you would have to repay a total of $1,050 as 5% of $1,000 is $50. This $50 is essentially the cost of the loan and how the bank makes its money.

Compound Interest

Compound interest is a bit more complex than simple interest and rather than simply calculating interest on just the outstanding balance of the loan, it also calculates interest at set periods during the life of the loan. When the bank calculates how much interest to charge or pay you, it looks at the whole balance of the initial loan and the other interest added. This means that unlike simple interest which only looks at the initial loan amount, your interest is stacking on top of each other. This can mean good things if you are depositing money to the bank, or ‘less good things’ as it can cost you more if the compound interest relates to a loan.

In Australia, most banks will use compound interest to calculate interest. Here’s how it works with your savings account. Say you have $1,000 in your bank account and each year your bank pays you 2% interest for banking with them, which is compounded twice a year. After 6 months, it’s time for the bank to pay you your first block of interest and they will pay you 1% as they pay you twice a year, they give you 1% now and 1% at the end of the year. You now have $1,010 in your account and given you don’t spend any of it, by the end of the year you will still have the same amount.

Now it’s time for the bank to pay you the last amount of interest they owe for the year which is 1% again but instead of calculating this on the $1,000 you had at the start of the year, they calculate it on the $1,010 you have in your account now meaning that you end up with $1,020.10. If this was calculated using simple interest you would have ended up with $1,020 and whilst 10c doesn’t sound like much, over time, this will keep earning interest and compounding more regularly meaning more money for in your pockets to spend on what you like – trust us, it will add up!

So, what next?

While interest rates can be a confusing topic to understand, we believe that the more you know, the better prepared you will be to find the right product when it comes time to apply for your next loan.

Looking for more? If you want to discover the ins and outs of interest rates and where they came from, be sure to check our other interest blog here:

What is Interest and Why Does it Exist?


Disclaimer: Any information provided in this blog is of a general and informative nature only. While all reasonable care has been taken by Pioneer Credit Connect in compiling this information, Pioneer Credit Connect makes no representations or warranties, whether express or implied, as to the accuracy or suitability of the information contained in this blog.