What Is an Interest Rate?

At its core, an interest rate is the price charged for borrowing funds from a lender – whether it’s a bank, building society, specialist lender, private lender, or fintech. More technically, the interest rate is the annual percentage rate (APR), charged as a percentage of your loan balance until you have settled the total amount.

Interest rates can be fixed or variable. A ‘fixed rate’ means the interest rate on your loan does not change over the life of your loan. Alternatively, a ‘variable rate’ is when the interest rate on your loan is based on an underlying benchmark or ‘index’ that periodically changes. 

A home loan is made up of two parts: the principal and the interest. The principal is the amount you borrow. The interest is the amount you're charged by the lender for borrowing the principal amount. Some loans are ‘interest only.’ The other option is a ‘principal and interest’ loan.

Interest rates will vary depending on many aspects, including your credit history and ‘risk profile.’ When the borrower is considered to be low risk by the lender, the borrower will usually be charged a lower interest rate. If the borrower is considered high risk, the interest rate they are charged will be higher, resulting in a higher cost loan.

Going into detail: the types of interest rates

There are several different types of interest rates, including:

Variable Interest Rate

A variable interest rate can be changed by the lender at any time. The constant fluctuations heavily rely on any changes in the decision of the Reserve Bank of Australia (RBA), changes in the regulations on how lenders operate, changes in the lender’s cost of borrowing, and even their business decisions in general. Based on these factors, your required loan repayment may increase as the interest rate goes up or decrease if the interest rate is down.

But if variable interest is unpredictable, why do homeowners take this type of loan? Here are some reasons why variable interest is often selected:

• The variable interest is usually a fair market rate. 
• Variable interest rates are usually flexible and have a range of features, such as offset accounts and redraw facilities features. These two features can help you reduce the amount of interest you need to pay. 
• You can choose to make extra repayments with variable interest,which can enable you to settle your obligation even before the term ends. 

On the other hand, a potential drawback of a variable interest rate is that it can be difficult to budget for, and make, larger loan repayments if the rate goes too high.

Fixed Rate

A fixed-rate interest rate is the opposite of variable interest: meaning that the rate is set and does not vary at any time over the life of the loan. A fixed-rate is often preferred by those on a tight budget who feel more comfortable committing to an exact amount. Moreover, if the interest rises, your funds are protected – meaning you won’t have to stress about needing to find extra funds to pay the higher interest.

A downside to fixed-rate interest rates is that you will be paying the same amount until the end term – even if the benchmark, or index rate, goes down. Additionally, this structure usually only allows scheduled payments, and there typically isn’t the option to have an offset account to reduce the length of your loan. 

Partially-fixed rate

Those who want to ‘hedge their bets’ often select a partially fixed and variable rate. In other words, one part of your loan is charged to your variable interest account, and the other portion of your loan is charged to your fixed-rate account. For instance, if you decide on a 50:50 split loan, 50% is set to the standard variable, whilst the other 50% is set to fixed-rate repayment. 

Introductory rate

A special interest rate is often offered by lenders for a specific period. This may be for six months or up to a couple of years. Once the introductory period expires, the amount reverts to the higher standard rate.