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You’re shopping around for a home loan, and one of the most talked about variables is what interest rate is being offered by which lender.
While there are many factors you should consider when choosing a loan, interest rates are significant, and a basic understanding of how they affect your loan will help you make an informed choice. So, how are interest rates calculated? And why are they worth considering when choosing your loan?
How are interest rates set?
The Federal Reserve Bank of Australia (RBA) is responsible for setting the ‘cash’ interest rate, which they review monthly and adjust to influence economic monetary policy. Once the RBA sets the rate, lenders can decide whether they either increase or decrease their interest rates in line with recommendations.
Why are interest rates so important to my home loan?
The interest rate will determine how much your repayments are. A small adjustment in the percentage, either way, can make a big difference to your repayments. Over the life of a loan, which is usually 25 years, just a slight move in a percentage point can make thousands of dollars difference to the total repayments.
Using the Yellow Brick Road home loan repayment calculator we’ve calculated an example based on a $500,000 loan. Paid monthly over 25 years with an interest rate of 3.75%, the total cost of the loan would be $771,196.80. At 4.00% interest for the same loan, the total cost would be $791,755.26. That’s $20,558.46 more at just 0.25% additional interest.
The three types of rate structures to consider when choosing your home loan:
- Variable rate
Choosing a variable rate means that your interest rate will go up or down when your lender makes any changes either way, either in response to RBA rate recommendations, or internal changes. The upside of a variable rate is that interest reductions are passed on to you, and the loan may be more flexible and allow you to make additional payments. The downside, of course, is that if interest rates rise, so will your repayments.
- Fixed rates
There are pros and cons of fixing your interest rate. Choosing a fixed rate when you take out your loan means you’re locking in the current interest rate for between 1 to 5 years. The advantage of this? If interest rates rise within that time, the increases aren’t passed on to you. The disadvantage? If there’s a rate decrease, that won’t be passed on either.
- Partially fixed rates
Choosing to fix rates partially can give you the best of both variable and fixed rates. Also known as a split-loan, you can choose to pay a fixed rate on a portion of your loan and a variable rate on the rest. This rate structure is a great way to enjoy the security of fixed, regular payments while still benefiting from the advantages of a variable rate, including possible interest rate savings and the ability to make additional payments on this portion of your loan.
What does it mean to my loan when the Reserve Bank makes its interest rate changes?
Some lenders amend their interest rate charges in line with the Reserve Bank’s recommendations, while others don’t. If you’re applying for a home loan, it may be worth shopping around.
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