The rate of interest you’ll pay on your mortgage depends on a combination of three key factors. These are the Reserve Bank of Australia’s (RBA) cash rate, your lender and the type of loan you have.
Reserve Bank of Australia (RBA)
The RBA meets monthly and they have the ability to adjust the cash rate in order to keep the Australian economy in a healthy state. Think of the cash rate as a ‘wholesale’ price for debt that Australian banks can access. After the GFC, we saw the RBA drastically reduce the cash rate to ensure mortgage holders disposable income would rise. As a result of this and other budget measures at the time, we were one of very few economies to avoid a recession. So put simply, the RBA can react to key indicators in the Australian economy by moving interest rates as they see fit. The interesting part of this story is once a change is made by the RBA, how much of the adjustment will each lender pass onto their clients.
The type of rate
Borrowers can choose to fix their home loan rate – or ‘lock in’ a rate for a set period of time. Currently, fixed interest rates for 1-2 years with all major banks are lower than their standard variable rate. This is an indication that they believe there will be further interest rate cuts in the next 18 months.
Some customers like the surety of fixed repayments as they are able to plan their monthly outgoings in advance. If you decide to move from a fixed-rate to a variable rate loan before the end of your fixed-rate term, you will be liable for break costs which can add up into the thousands.
Alternatively, a split loan can give you the best of both a fixed-rate and variable-rate loan. This means that if rates rise, a proportion of your loan will be protected – minimising the impact of higher monthly repayments. If on the other hand rates fall your fixed-rate will remain higher and the variable part of the loan will fall.
The type of loan
Different loan types tend to come with different interest rates. So if your loan has a range of features, such as re-draw, offsets or early repayment facilities, you’ll usually pay a little more in interest. Alternatively, while a basic loan doesn’t have all the bells and whistles of other products the interest rate is typically lower.
For example, if you’re looking to drive your mortgage down quickly or would like flexibility in your repayments, it may be worth paying for the features needed to do this most effectively. If your monthly pay fluctuates due to commissions, an offset account would be a good feature to have. If you are a first home buyer and your mortgage is your only major financial product, then a simplistic loan would probably suit.
3 Tips to reduce the impact of a rate rise
1. Factor in possible rate increases
Leave room for a number of interest rate rises when you assess your borrowing capabilities. This is essential, particularly as rates are likely to rise at some stage during the life of your loan. Having extra cash stored for this purpose in an offset account is a great strategy.
2. Changing your repayments to interest only
If you have a loan and you’re really struggling to keep up with rate hikes, you can consider changing to an interest-only loan. While not an effective long-term strategy for owner-occupiers, it might be an option while you deal with the here and now.
3. Refinance
Your situation may have changed from when you first took out your mortgage – for example, you’ve now only got one person in the household earning a salary. Rates between lenders are also changing dramatically as competition amongst lenders increases so reviewing your rate will no doubt result in finding a cheaper option.