Understanding home loan interest rates

Understanding home loan interest rates

When choosing a home loan, it is important to find the right interest rates to suit your situation. But with so many rates available from so many different lenders, finding the right one can be overwhelming.

How do rates get set, what are the different types and what does comparison rate mean? Here we explain everything you need to know about interest rates to help you be well prepared for the homebuying process.

How are interest rates determined? 
Interest rates are mainly determined by two things:

1. The cost for a lender
The cost for a lender is based on the official ‘cash rate’ for the money market, set by the Reserve Bank of Australia (RBA). When the official cash rate goes up, so do interest rates. And lenders would typically pass the cost increases on to customers. These market changes only affect variable interest rates (also called floating rates).

2. The 'risk' to the lender
The other important factor around how rates are set is the risk of lending money to a particular customer. First, a lender looks at the amount of money someone has to put into a property versus how much they are wanting to borrow – called the Loan to Value Ratio (LVR). LVR gives them a good idea about how much borrowing power a person has and the potential risk of lending to them. Basically, the more money a person has saved to put into the property, the lower the risk – which is why saving a good-sized deposit is important. 

Lenders will also look at a person’s ability to repay the loan, by checking key things like previous credit history and current financial situation. This overall assessment will determine whether a loan can be offered, and at what interest rate. At Pepper Money we use a form of risk-based pricing. This careful process of personal assessment and pricing is what makes us different to the traditional lenders and allows us to provide more types of loans to help a far wider range of people. As a general rule, Pepper, like all lenders, wants to be sure that the loan repayments will be able to be comfortably managed within a person’s circumstances and not create hardship.

What are the different types of interest rates (fixed vs variable)?
There are two types of interest rates – fixed and variable. Fixed interest rates will stay the same for the full term of the loan agreement, generally between 1 to 5 years and you’ll pay the same amount at each payment cycle (fortnightly or monthly). With variable interest rates, your loan rate and repayments will go up and down depending on the interest rate changes. This can be helpful if rates go down as the amount of interest you pay will get reduced, but they may also go up making budgeting a challenge. Another benefit of choosing variable rate loans is that it usually gives you the flexibility to make extra repayments or repay your loan in full ahead of the loan term, without paying any additional fees. Learn about the pros and cons fixed vs variable rates here. Note that Pepper does not offer fixed rate loans at the moment – but we are working on it).

Tip: Not all rates are advertised by all lenders. For example, a loan provider might advertise a standard variable interest rate, but they might also have rate discounts or alternative loan options, for example, like interest-only for a number of years. So, it’s a good idea to ask them to take you through all the options they have. 

What’s the difference between an interest rate vs a comparison rate?
Interest rates play a big part when deciding which home loan is best for you. People often focus on the advertised rates without knowing how much a mortgage will really cost. But this is when you need to pay a little more attention to the comparison rate.

The Comparison Rate shows you how much interest you are paying on the loan when all fees and charges are added in, providing you the true cost of the loan, versus the interest rate on its own. Here is a simple example:

  Interest Rate Fees & Charges Comparison Rate
Loan A 4.50% 0.5% 5%
Loan B 4.75% 0.1% 4.85%

As you can see in the table above, Loan A looks more attractive by interest rate – but – when you look at the Comparison Rates that include all the costs, Loan B is the better option.

It is important to understand your exact repayments amount before committing on a mortgage, to ensure that it is affordable for you in the long run.

Tip: As well as understanding the complete costs, you should also compare home loans for any different product features that you are interested in, such as not having any restrictions on early repayments.

Where can I get more information?
Remember there are no silly questions. Always ask. Here are some quick tips:

  • Ask the specialists. Visit a number of lenders and get some advices from their lending experts, or reach out to a broker in your area who can take you through the process and explain everything along the way
  • Get some insights from your own networks. Ask your family and friends for their experience with the lenders you're looking at. You may not have dealt with them before, but others may have.
  • Check for their reviews online. Get a quick overview of how different lenders compare by visiting online comparison site such as Finder, Canstar or Comparethemarket.

Ready to get started? Try our Mortgage Repayment calculator to see what repayments could look like on a Pepper Money home loan. Or if you'd like to know more about our home loan options, enquire online or speak to one of our friendly Lending Specialists on 13 73 77 between 9am and 6pm

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