Life after lockdown: What’s going on with interest rates and how do they affect my home loan?

At the start of 2020, we all thought a Corona was something that came with a wedge of a lime and went alright on a hot day. Six months on, the virus of the same name has upended life as we know it and affected pretty much every aspect of our day-to-day routines. In the third and final instalment of this three-part series, we look at the impact that COVID-19 has had on Australian interest rates – a seemingly small but important number when it comes to your first home loan.

Unless you chose to spend lockdown under a rock, or are so deep in a ‘Rona-induced Netflix binge that you’ve forgotten what it’s like to interact with actual real-life humans, chances are you’ve heard plenty of talk about interest rates over the past few months.

Even before coronavirus sent everyone into a spiral of toilet paper panic-buying, interest rates were a hot topic of conversation. This time last year, the Reserve Bank of Australia (RBA) cut interest rates to 1.25% – the first time they had dropped from 1.5% since August 2016.

Twelve months on, the freefall has continued. By March 2020, as Kleenex flew off the shelves and the economy was really starting to cough and splutter from the effects of COVID-19, they had dropped even further to 0.25%, where they’ve stayed ever since.

So what’s this got to do with me buying a house?

Interest rates are affected by a number of different factors, some of which require an economics degree to understand, but it boils down to this – interest rates will directly impact how much you end up paying over the life of your home loan.

If your folks were buying property in the early ’90s, you’ve probably heard them moan about how much more they had to pay in interest than you do now, and they’re not lying. Back when everyone was wearing parachute pants and watching Melrose Place, interest rates were around 17% (OK Karen, but house prices weren’t as eye-watering as they are now, so you still had a pretty good deal).

So while current interest rates are much more palatable, it’s still important to do your research and shop around – even seemingly small differences can have a big impact on what’s left in your pocket at the end of each month.

Understanding different types of home loans

Although the RBA’s cash rate is the reference point, unfortunately it’s not the number that will be stamped on your home loan documents. Banks are businesses, and will build in their own fees and charges to arrive at the interest rates that they pass on to customers.

At the moment, the lowest rates in the market are hovering around the 2.2% mark, but the average rate is closer to 3.25%. Interest rates not only differ between lenders, but also between types of home loans. Here are some of the main things that will affect your interest rate:

Loan to Value Ratio (LVR)

This is the amount you’re borrowing as a percentage of the property’s value, as determined by your lender. For example, if your dream house is worth $750,000 and you’ve got a $150,000 deposit, you need to borrow $600,000, or 80% of the property’s value. Lenders like an LVR of 80% or less because the loan carries less risk, so they will typically reward you with a lower interest rate. If your LVR is higher than 80%, you may also need to stump up for Lenders Mortgage Insurance (LMI).

‘Principal and interest’ vs ‘interest only’

That $600,000 loan you’ve just been approved for? It’s not going to stay $600,000 for long, as interest will start accruing almost immediately, at whatever rate you’ve been given by your lender. But there are a couple of different ways you can start to pay this down each month – ‘principal and interest’ or ‘interest only’.

‘Principal and interest’ means you’ll be paying off both the lump sum you’ve borrowed ($600,000) and the interest that’s building up on top. ‘Interest only’ gives you the option of just paying the interest for a certain amount of time (say, five years), before you are required to start chipping away at the principal balance.

This might sound tempting because it means lower repayments in the short term, but that principal balance ain’t going anywhere – you’ll still have to pay it off eventually. You also end up paying MORE over the life of the loan, as you’re not reducing the amount of the principal balance for the initial interest-only period, and interest only options can also attract a higher interest rate.

Fixed vs variable rates

As we’ve discussed above, not all interest rates are created equal – and are often subject to change, as we’ve seen in the volatility of the past few months. This is why it’s important to weigh up the various pros and cons of a fixed or variable interest rate for your home loan.

A fixed interest rate will see your interest rate locked in for a certain period, which could be anywhere from one to 10 years. This means your repayments won’t change during this period, regardless of whether general interest rates go up or down. On the flip side, a variable interest rate can change at any time and for a variety of reasons, from the monthly interest rate decisions of the RBA to other economic factors. If interest rates go down? Great, so will your repayments. But if they go up? Yep, so too will your mortgage bills – whether you like it or not.

Comparison rate

You’ve been doing your research like a good little future home owner, but what’s this other number you keep seeing next to the advertised interest rates on lenders’ websites? And why is it always higher? That’s the comparison rate, which factors in both the advertised interest rate and the upfront and ongoing charges that will add to the total cost of your home loan. All lenders are legally required to publish the comparison rate, so you can compare loans fairly without getting any nasty surprises once you’ve signed on the dotted line.

When it comes to home loans and interest rates, it may seem like there’s a lot to think about but it’s worth doing your due diligence – 2.2% versus 3.5% might seem like a miniscule variance now, but that could potentially translate into thousands of dollars’ difference over the life of your home loan.

Luckily, your mortgage broker is on hand to help you navigate your options and arrive at the best one for you – so you’ll have plenty of cash left in your pocket for toilet paper when the next once-in-a-lifetime pandemic hits.

Catch up on Part One and Part Two of our ‘Life After Lockdown’ series to find out more about how COVID-19 has affected the property market, and what you can do to maximise your chances of securing a home loan.

The material on this website is of the nature of general comment only, and does not represent professional advice. It is not intended to provide specific guidance for particular circumstances, and it should not be relied on as the basis for any decision to take action or not take action on any matter which it covers. Readers should obtain professional advice where appropriate, before making any such decision. To the maximum extent permitted by law, the author and publisher disclaim all responsibility and liability to any person, arising directly or indirectly from any person taking or not taking action based on the information in this publication.

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