The question of whether you are ready to climb into the real estate market and make your first, (or next) property purchase really comes down to just one thing; are you able to commit to a mortgage?

For most people, owning their own home means getting into debt.

If you are like most people, you’ll need to borrow money to pay for the property you purchase, which means you’ll need to pay back what you owe, with interest. That interest can have a big impact over time, so it’s important to understand what your interest rate options are and how they work so you can make financial plans and set your property purchase budget accordingly.

Many people do not understand their interest rate, they are simply happy to have access to a loan, even if that means they are paying more.

In a survey of 586 mortgage holders, Finder found that 38 per cent of respondents had no idea what their interest rate actually was. When you don’t understand your payments, you don't have control of your financial situation and you have no ability to make the situation you are in work in your favour.

First up, it's important to know that interest rates can fluctuate. All lenders are allowed to act independently and set whatever interest they want. The arrangement is a private negotiation between the lender and the borrower so the amount set is dependent on supply and demand in that particular circumstance.

The change in rates over time is significant and can make a big difference to the length of the loan, how much you borrow and the total amount you will pay overall.

If we spin back to the 1990s, the usual home loan at the time was 17 per cent. In the 2000s the average home loan interest rate was 8-9 percent. In 2020, the average was 4-5 percent.

Given that your home loan will probably take some time to pay off, it’s important to look further than just the current interest rates, especially if you prefer to take a variable loan option.

How do interest rates work?

The Reserve Bank of Australia (RBA) is responsible for determining the Australian currency and ensuring we are not overspending on the current cash reserve. It’s their job to maintain Australia’s financial security.

Interest rates are announced using the RBA Cash Rate Target. The RBA board meets once a month to look over the cash rate and determine the benchmark, with the overall target being of zero risks to the Australian dollar.

Using facts and figures on Australia’s economic standing, the RBA determines if the interest rate on the bank’s loans will stay the same, be lowered, or can be raised for that month.

The benchmark set is the cash rate target. This target is used by the RBA to charge interest on unsecured loans between the banks that night. So basically, once a month the banks are charged a certain amount of interest, based on what Australia can afford, which the banks then pass on to their customers, well, if they want to.

It’s really important to note that these are just recommendations. The RBA is not there to regulate the lenders or set the rates, they simply suggest what will work best financially. The banks can turn their back on the advice and set their interest rate. Overall though, they want the best for the economy. If everyone goes broke because the rates are too high, the banks and lenders lose.

It’s in everyone’s best interest for interest rates to be realistic and achievable.

The other factor that keeps the lenders all hovering around the RBA recommended rates is competitiveness. No one is going to want to get a loan from the provider who charges 8% more than the others, they are going to go to the cheapest provider for their loan. That means all the lenders are fighting to keep their interest rates as low as they can so that customers will choose who they take a loan from based on terms and conditions, brand familiarity and marketing.

Most business lenders find the best way to stay competitive on the market is to match their rivals.

It’s completely up to each bank and lender how to apply the interest. They may choose to match an RBA rate cut in full or keep the same fee for the customer even if a rate is cut. In some cases, they will match it, but it may take three weeks to be applied.

Typically banks and lenders choose to reduce the interest rate of either fixed or variable home loans. It all depends on your contract with them, which explains why understanding this is so important to your wallet.

All these items will be listed in your terms and conditions of your loan agreement, so be sure to read over the fine print to know where you stand and what you can expect with your ongoing repayments.

Why are interest rates so different on fixed and variable?

Because the RBA cash target isn’t known until the next board meeting (the first Tuesday of every month), banks need to be a little flexible with their loan options. They can’t fix a home loan at the lowest possible interest rate, should the RBA charge more in subsequent cash rate targets, the bank will lose money. That is why fixed rates are set at slightly higher rates than variables and the RBA recommendation. Month to month variable interests means that the bank will charge you a lower fee, only so long as the RBA only charges them the low fee too.

Interest rates are not a case of one size fits all. Your circumstances will also be a contributing factor when it comes to what interest rates you will be offered.

As well as their competitor’s rates, other factors that influence when and how a lender will change their rates include:

- The lending risk

- Lender’s interest rate structure

- Lender’s deposits

Lenders will usually be happy to pass on a rate decrease or partial rate decrease to satisfy current customers and attract new ones.

If your lender isn’t one of those passing on rate reductions and you feel your credit history is good, you can arrange a meeting to negotiate your loan.

It’s a good idea to shop around to see what other providers can offer if you switch your loan to them, however, you must calculate the exit fees, including discharge and break fees for your current lender as well as the establishment fees and stamp duty when you move to the next one. These can be high and might not be worth the money saved from the reduced interest rate overall.

It is so important to factor the cost of your total interest into your loan and understand the commitment you will be making. It’s so important not to overspend or overstretch your budget or overlook your interest agreement. Knowing what the property is worth is crucial for understanding where you stand in terms of your future investment.

We’ll go over the options of fixed and variable rates in more detail in our next blog, Different Home Loan Options Explained, where we’ll also explain how to use comparison rates to understand the full cost a provider is asking of you, taking into account the loan products as well as the various fees and charges. Stay tuned for our next04/23/3 post and as always, the research you do before you buy is essential for a great investment.