Interest Rates Explained: How to Understand Interest Rates, Including the Differences Between Fixed and Variable Rates | Answers to your mortgage questions

Property is the biggest purchase we will ever make. However, most people don’t have that kind of money to spend and have to borrow some of the funds from a lender.

So what’s in it for the banks? A big plus is the interest they charge us for the privilege of paying off a house over time.

There are many factors regarding interest rates that are important to understand before getting a home loan, such as how interest rates are calculated and the differences between fixed and variable rates.

Here are eight common questions answered by you.

What are the interest rates?

Interest rates are the fees a lender charges you to borrow money, expressed as a percentage of the principal sum (total amount borrowed or lent). The amount of interest is set by both your bank and the official Reserve Bank of Australia (RBA) exchange rate.

The RBA is responsible for issuing Australian currency and maintaining financial stability.

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How are interest rates calculated?

“Banks calculate interest rates in a number of ways,” says Beau Cook, mortgage broker at Loan Market. “Typically banks look at the cost to them of borrowing the funds and add a margin to that and then lend you that money.”

“For variable rates, it is largely tied to the cash rate which is set by the RBA,” he says.

Every month (except January), the RBA reviews the current cash rate, assesses the state of the economy and then decides whether it will hold, raise or lower the cash rate.

“Fixed rates have a little more to do with bonds, hence the difference,” adds Cook. “The price of bonds generally reflects market conditions expected in 1.2 to 3 years.”

Do banks pass on interest rate cuts?

Homebuyers should be aware that anything goes when it comes to passing on interest rate changes.

“Banks pass on rate cuts in full, not at all, or somewhere in between,” Cook says. “And lenders can make their own decisions about that.”

Although some lenders will pass on any reduction in an effort to retain existing customers and attract new ones, this is not something you should expect. Therefore, it is the individual’s responsibility to ensure that they do not pay a rate above market value.

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Keeping up with monthly RBA changes is a good habit to get into, and Cook recommends having a trusted mortgage broker on hand.

“The best way to make sure you’re not paying too much is to talk to a broker because they can check market rates and negotiate with your existing lender to see if your current rate can be reduced,” Cook says.

“You can also call your bank to ask for a rebate. There’s nothing wrong with that,” he adds. And if that fails, you might consider switching lenders, factoring in discharge fees.

What is a comparison rate?

Comparison rates help buyers understand what their loan is really going to cost. This rate takes into account interest rates, plus any fees and charges, so you can compare like with like when choosing a loan.

“A comparison rate takes into account the variable interest rate plus any fees you’ll pay over the course of the loan, assuming you pay the minimum amount each payment cycle,” Cook explains. “They convert that fee from a dollar amount to a percentage against your home loan.”

“Imagine you had a $450,000 loan with a 3% interest rate and you were going to pay $15,000 in fees over a 30-year term. That would be 0.11% per year in fees compared to the $450,000 loan.

“This percentage is added to your interest rate and gives you your comparison rate, which in this scenario is 3.11%,” Cook explains.

What are fixed and variable interest rates?

Unfortunately, choosing a home loan isn’t as simple as finding the lowest interest rate. There are different types of interest rates, with pros and cons, that you’ll need to understand in order to choose the right option for your goals and lifestyle.

A fixed interest rate is a fixed interest rate for a period of time, which can be useful when planning a budget because you will pay a fixed amount of monthly interest. It’s usually hard to get out of it, so it’s important to research the best deal before you lock yourself in.

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Variable interest rates will reflect market changes and the official RBA exchange rate. This means that your lender could increase or decrease your rate and these changes will affect the amount of interest you pay.

If interest rates go up, you might feel the pressure, but at the same time, if rates go down, you will reap the rewards.

What are the differences between fixed and variable interest rates?

“Fixed rates usually have restrictions on additional repayments,” Cook explains. “Variable interest rates allow you to make additional repayments without any penalties or restrictions.”

Cook says the downside of a fixed rate is that many lenders will only allow an additional $10,000 per year in repayments and if you want to close the loan within the set time frame, “you may be liable for break fees, which can be thousands of dollars pending bank and market conditions at the time of loan closing.”

“However, the benefit of a fixed rate is the certainty of repayments,” he adds. “This is advisable if, for example, you expect a temporary reduction in your income.”

This could be for a number of reasons, such as having a baby, taking time off to improve skills, planning a wedding, dealing with health issues, or any other temporary reason of reduced income.

“A fixed rate may work for you in a scenario where you can live on temporarily reduced income without worrying about increased repayments while living on less.”

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But if you’re in a situation where you’re hoping to make additional repayments above a $10,000 cap, variable rates might be right for you.

“If you plan to make additional mortgage payments above $10,000 per year or expect to be able to make large repayments in the near future, i.e. within a few years, I would choose variable rate,” advises Cook.

“However, with either option, you need to be prepared for rate hikes. When the fixed rate ends, you’ll enter the variable rate at that time.”

What is the difference between an interest only loan and principal and interest?

There are two types of loans: principal and interest (P&L) or interest only. The type of loan you choose will depend on your reasons for buying the property, as well as your financial situation.

The principal amount is the amount of money you borrowed, so “principal and interest” means paying that amount back plus the interest charged by your lender. Although you’re technically paying more because you’re repaying two items, P&L loans generally have more competitive interest rates.

“Principal and interest means paying more but reducing the amount owed on the loan,” Cook explains.

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Ultimately, you’re slowly paying off the home, allowing you to increase the equity in your property and reduce the amount of interest you pay over time.

Interest-only loans will allow you to repay only the interest portion (along with any associated fees) for a fixed term, usually up to five years.

“Interest only means paying the bare minimum to reduce the amount payable to the bank on each payment cycle,” Cook explains.

“Interest-only loans generally attract a higher interest rate, while also not reducing the amount you owe, so there are obvious downsides.”

Once this period is over, you will need to start paying back principal and interest, which will mean higher repayments. It is important to ensure that you are able to afford higher repayments before choosing this loan.

When would you choose an interest-only loan?

Interest-only loans are commonly associated with real estate investors because they can free up money for other investments and offer tax deductions on interest paid.

“The reason for interest-only loans is to free up cash flow, which can be spent on other opportunities,” Cook explains.

The most common scenario Cook sees is where a landlord with an existing P&L loan purchases an investment property. Using interest only for investment property reduces repayments, say, by $500 per month. This $500 would be used to pay off the P&L loan as it is not tax deductible.

“They would like to pay off their existing homeowner mortgage as quickly as possible. Once the non-tax-deductible debt is cleared, the tax-deductible loan (interest only) would begin to be paid off,” Cook adds.

“It’s always best to talk to your accountant or financial planner if you’re considering an interest-only loan.”

The information provided on this website is of a general nature only and does not constitute personal financial advice. The information has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any information on this website, you should consider the suitability of the information to your objectives, financial situation and needs.

Leslie M. Gill