If you have a mortgage, or are planning to get one, understanding the relationship between interest rates and home loans can be very useful. This understanding could even help you make decisions about your mortgage and how you choose to pay it off over time. So what is the connection between interest rates and home loans? Let's take a look at the key points.
What are interest rates?
An interest rate is the amount a lender charges someone to borrow money. It's calculated as a percentage of the loaned amount, which is known as the principal. If you've have taken out a home loan, the interest rate determines the amount you'll pay on the principal while you have a mortgage.
An interest rate is set by each individual lender, but it can also be influenced by the official cash rate set by the Reserve Bank of Australia.
What is the official cash rate?
The Reserve Bank of Australia (RBA) is Australia's central bank, and one of its primary roles is to conduct monetary policy and maintain a strong financial system in Australia. The RBA can choose to adjust the official cash rate in relation to things like inflation, employment and economic growth.
Australia's cash rate determines how much banks have to pay to lend and borrow from each other overnight. As such, the cash rate can directly influence interest rates and therefore shape behaviour in the economy, such as spending or saving. The RBA can choose to either raise, lower or keep the cash rate the same to maintain stability, at any of its eleven meetings per year. When the cash rate changes, interest rate changes can follow.
What happens when interest rates rise?
If the RBA decides to increase the official cash rate, lenders generally raise their interest rates soon after. Rising interest rates can have a number of effects. People might feel less encouraged to spend and more encouraged to save, because they can gain greater interest from a savings account. Borrowing money becomes more expensive, and there's typically less spending on goods and services. This in turn can slow down economic inflation, which helps keep the prices of goods and services from rising too high.
The opposite can happen if the official cash rate is lowered. People might feel less encouraged to save and more encouraged to spend, as savings earn less interest than they did before. Borrowing money becomes less expensive, so spending on goods and services tends to increase. This can encourage economic growth.
Interest rates are all about balance and keeping the economy at a healthy level of growth without allowing too much inflation. So what does this all mean for a home loan?
How can interest rate rises impact home loans?
If the RBA decides to increase the official cash rate, home loan interest rates tend to rise too. This means that with a variable home loan, the minimum regular repayments may increase. The same happens in reverse too. If the cash rate and interest rates fall, then minimum repayments could become lower as lenders pass on the savings.
This is one of the reasons why it can be so helpful to understand the relationship between interest rates and home loans: because whether interest rates rise, fall or stay the same could potentially affect the amount you pay over the course of your home loan.
What can you do for your home loan during rate rises?
There are a number of options a homeowner could consider around an RBA interest rate rise. Of course, the best course of action will depend entirely on the individual's circumstances. Two of the possibilities are to refinance, or to move to a fixed rate loan.
Refinancing
Refinancing a home loan means changing loans to take advantage of a different rate or terms, either with the same lender or a different one. Refinancing could allow a borrower to change from a variable home loan to a fixed rate loan or vice versa; to find a different interest rate; or to change the duration of the loan. With Qudos Bank there's also the option of dividing a home loan into multiple accounts across different variable rate products.
Refinancing offers the opportunity to shift to a new loan or loans with better terms and rates. In this way, refinancing can be used to reduce the interest paid over the course of a home loan.
Moving to a fixed rate
Fixed home loans work by locking in a certain interest rate for a set period of time, usually one to five years. If an interest rate rise is expected, one possible course of action is to take advantage of a fixed rate loan. If used successfully, a borrower can potentially safeguard themselves against higher interest rates until the term of their fixed rate loan ends. It's important to take all costs into consideration for a fixed rate loan, which is where the comparison rate can come in handy.
What is a comparison rate?
A comparison rate helps borrowers to assess the true cost of a loan. Where a simple interest rate may not necessarily factor in any of the fees and charges relating to a home loan, a comparison rate takes into account interest rates as well as fees and charges that are definitely payable on the loan.
In Australia, lenders are legally required to show a comparison rate alongside the interest rate of a home loan product. Home loan comparison rates are calculated based on a $150,000 loan over a 25-year loan period to make it easy to compare different products. It's worth noting that there may be some rates and charges that are not reflected in the comparison rate, such as Government charges.
The best home loan terms can be different for every homeowner, which is why it's important for every person to consider their own circumstances when making these kinds of decisions.
Have questions?
Our team at Qudos Bank is here to help, whether you're looking to secure your first home loan, refinance or simply assess our flexible home loan options. You can get in touch today to speak with a Lending Specialist and to find answers to any questions you might have.
