Home Loan Interest Rates & Inflation- Making Sense Of It All

A Guide to Understanding the Australian Market

If you’re looking to make the most of your money, it’s essential to understand interest rates, inflation, and how they impact your finances. Whether you’re looking to save, invest, or purchase a home, interest rates play a crucial role in determining the financial landscape. Let’s take a closer look at some key terms and concepts that you should know.

What are Interest Rates?

An interest rate is the cost of borrowing or lending money, expressed as a percentage of the amount borrowed or invested. When you borrow money, you pay interest on the amount borrowed. When you save money in a bank account or invest in a bond, you earn interest on the money invested. Interest rates are determined by supply and demand in the market, as well as factors such as inflation, economic growth, and government policies.

Once crucial factor to note is that when you borrow to purchase a home, interest is compounded on a daily basis, whilst when you are paid interest on a high interest account it is simple interest. That is why those who are saving for a deposit find it hard to keep up with the amount of deposit required.

The RBA(Reserve Bank of Australia) meet on the first Tuesday of the month to determine whether to increase the cash rate(which is the interest rate at which banks can borrow or lend money overnight) or not depending on the other indicators in the economy.

What is Inflation?

Inflation is the rate at which the general level of prices for goods and services is increasing over time. It’s measured by the Consumer Price Index (CPI), which tracks the price changes of a basket of goods and services commonly purchased by households. Inflation erodes the purchasing power of money over time, meaning that the same amount of money will buy less in the future. Inflation, similar to interest rates is influenced by a variety of factors, including supply and demand, currency exchange rates, and government policies.

How do Interest Rates and Inflation Affect Your Money?

Interest rates and inflation have a direct impact on your financial situation, particularly when it comes to savings, investments, and borrowing. When interest rates are low, it’s generally cheaper to borrow money, but you’ll earn less interest on your savings. Conversely, when interest rates are high, you’ll earn more interest on your savings, but borrowing money becomes more expensive. Inflation also affects your finances, as it can erode the value of your savings over time. Therefore, it’s essential to consider both interest rates and inflation when making financial decisions. Depending upon the economic environment you may not even get a CPI indexed increase in wages every year. When this happens you go backwards as your salary has not kept up with inflation.

If you want to understand more about where inflation is heading read this article.

Home Loan Interest Rates

If you’re looking to purchase a home, you’ll need to consider home loan interest rates. These rates are determined by a variety of factors, including the Reserve Bank of Australia (RBA) cash rate. When the RBA cash rate is low, home loan interest rates tend to be lower, making it more affordable to purchase a home. However, if interest rates rise, your home loan repayments will increase.

Borrowing to purchase a home

Most of us will have to borrow from the bank to purchase a home. You maybe amused to know the origin of the word “mortgage”. In French “mort” means death and “gage” means pledge. So it’s like a pledge until your death !. Sounds morbid doesn’t it ? Well in reality it’s not so far from the truth. Say you purchase your first home when you are 30 and take out a 30 year home mortgage loan , if you do not make any extra repayments you will be 60 when you repay the loan. It’s almost the length of your working life.

Tips to navigate your home mortgage loan

1. Have a solid understanding of “Why” you want to purchase a home. Do not do it because everyone says that is the smart thing to do.
2. It’s not the end of the world if you do not have a 20 % deposit and have to pay LMI( Lender’s Mortgage Insurance) which by the way protects the bank and not you.
3. Do not overextend yourself. If the published rate is 5.00% , see if you can make the repayments if the interest rate climbs to 7.50%. The bank will do this when they determine whether to lend to you or not but you are better prepared if you know your own repayment capacity.
4. If you have just changed jobs get your pre- approval done only after your probation period is complete or your have at least 3 consecutive payslips. ( Each bank will have their own criteria but these seem to be standard.) If you are self employed you must show at least two years of lodged tax returns so that they can see the stability of your income.
5. Using many of the calculators available online check whether you are able to service a 25 year loan. Double check your paperwork before you sign on the dotted line. This happened to me. Though I had chosen 25 years, it showed 30 years on the paperwork. I asked them to change this before I signed. On a $800,000 loan at 5.00 % interest you will pay $143,000 less in interest just by choosing this option.
6. Choose the weekly repayment option.
7. Choose the product depending on what you need and not what the bank gives you. For example a redraw account feature maybe cheaper than one with an offset.
8. When you get a one off lumpsum of money say a tax refund or a bonus , try put a part of it in your home loan account. This will be a buffer for you when interest rates rise or you lose your job.

Fixed versus Variable Rate

This always proves to be a difficult decision. Some like to go with a 50 %/50%. They are in effect hedging their exposure. In 2009 when we borrowed interest rates were 6.15%. As we went directly with the lender I asked our mortgage officer on what she thought we should do. She felt it would come down as we were in the aftermath of the GFC of 2008. Boy! she was right. If we wanted to fix the rate, it would have been 7.15 % or so. The interest rate came down steadily over the years till the recent spike in 2021.

An example showing the difference in total costs;

John is a first-time homebuyer looking to purchase a $500,000 property. He plans to borrow $400,000 over 30 years, with a 20% deposit of $100,000. John is considering two different home loan options from his bank: a fixed-rate loan and a variable-rate loan.

Option 1: Fixed-Rate Loan

The fixed-rate loan offers an interest rate of 3.5% for the first three years, after which the rate will revert to the variable rate. The bank also charges a $500 application fee and $300 annual fee for this loan.

Option 2: Variable-Rate Loan

The variable-rate loan offers an interest rate of 3.25% for the first year, after which the rate may fluctuate based on market conditions. The bank charges no application fee and a $200 annual fee for this loan.

Now let’s compare the two loan options over the first three years:

Fixed-Rate Loan:

• Loan amount: $400,000
• Interest rate: 3.5%
• Loan term: 30 years
• Monthly repayment: $1,796.18
• Total interest paid over three years: $27,459.49
• Total cost over three years: $28,959.49 ($27,459.49 in interest plus $1,500 in fees)

Variable-Rate Loan:

• Loan amount: $400,000
• Interest rate: 3.25% (for the first year)
• Loan term: 30 years
• Monthly repayment: $1,739.18
• Total interest paid over three years: $25,372.34
• Total cost over three years: $25,772.34 ($25,372.34 in interest plus $400 in fees)

So we can see that the there are other costs to consider as well to gain an overall picture of costs.

Summary

For most people this is not a topic of interest but rather one of dread and anxiety. It needn’t be that way. If your income is lumpy, start putting away money during your good times. If you are planning to have children get a loan approved before that. It sounds harsh but banks are very wary of women on maternity leave. In most cases they want to see the term of your maternity leave and a letter from the company stating your return date!.

Do your homework and especially do your math homework ! With the range of free calculators and budgetary tools available online you will be able to determine your borrowing capacity quite easily. Do not shop around trying to get the maximum borrowing capacity. There is a reason why you have been denied and though you will hate the bank at the time it could be for your protection.

If the current environment is too overwhelming to make a decision, do not fret. Continue to save your money in a high interest account( the only benefit of high interest rates!) and read up more about investing or even rent vs buy and the long term return of property versus the share market to determine the best place to park your money.