How changing interest rates affect mortgages
Australians are experiencing a changing interest rate environment which may directly impact your finances. Read more to find out how interest rates work, and what you can do to manage these changes.
What are interest rates
Interest rates refer to the ‘price of money’ in the economy. It is expressed as an annual per cent. For example, a 5% interest rate is equivalent to 5% of the borrowed sum on an annual basis.
How are interest rates set
The general level of interest rates in the economy is set by a range of factors, but the main reference point is the overnight cash rate set by the Reserve Bank of Australia (RBA). Decisions about the overnight cash rate are made on a monthly basis by the RBA with the exception of January. In Australia, the RBA meets on the first Tuesday of every month.
Why is the cash rate & interest rates on home loans different?
Commercial banks are primarily in the business of sourcing funds (for example, through customer deposits), and then ‘lending’ those funds to customers. The difference between the interest rate paid on funding sources and what it is lent to customers for is the profit margin on lending products. Naturally, this means that the rate that a borrower receives is higher than the “price of money” in the economy otherwise the bank would not make money.
There are a range of factors and inputs that determine your interest rate. These include:
The cash rate as referred to above
The borrower’s risk profile (identified through your application to the banks for credit)
Bank-specific factors such as their costs
Market competition.
How interest rates (in particular, rate changes) affect you
Since interest rates reflect the cost of borrowing money, as interest rates change, the cost to a borrower may change.
At the time of writing, September 2022, the Australian economy is on an cash rate tightening cycle with a range of consecutive increases in rates decided upon by the RBA.
This may affect you in a few ways, and we’ve provided a summary below.
Loan servicing [i.e. can you meet the monthly repayments?]
If you are a prospective borrower, it may reduce your loan-servicing ability. Basically, when assessing your application banks consider the cost to service a loan taking into account interest rates plus a buffer on top of that (currently 3%).
As rates rise, the interest rate and therefore loan interest repayments rise for borrowers, which means they have less ability to service a ‘large’ loan size.
For example:
If you wish to take out a loan of $500,000 at an interest rate of 2.0%, your monthly principal & interest (P&I) repayments would be $1,849 on a 30 year loan term.
If the interest rates increased by 3% resulting in an interest rate of 5%, your new monthly P&I repayments would be $2,685.
That is an increase of $836 per month.
Borrowing capacity
Related to loan servicing is borrowing capacity. This is how much your financial circumstances allow you to borrow from the banks. As interest rates increase, your borrowing capacity is likely to reduce in line with your ability to repay the debt.
Debt to income (DTI) ratio
A key test for lenders in their assessment of you as a borrower is your DTI ratio. This is calculated as your:
Total debt / your gross income
Assuming your income remains unchanged but the price of properties decline as a result of interest rate changes, you may find your DTI increases, supporting your borrowing capacity
What can you do about changing interest rates?
Firstly, don’t panic! Your first port of call is to get in touch with a qualified mortgage broker who specialises in assessing your circumstances and providing credit advice. If you’d like to discuss refinancing, purchasing a property or are interested but still unsure, contact us to discuss your options.
