Home Loan Interest Rates Explained

Home Loan interest rates are at all time lows in Australia – that’s great news for borrowers, right? Well, yes – while this is true, time never stands still, and just as interest rate decreases have been common recently, in other periods in recent history interest rate increases have meant that rates have been sky-high.

So, have you ever actually stopped and wondered – why do interest rates change? What are the driving factors behind interest rate fluctuations, and can you be better prepared for them as a borrower?

Key takeaways:

• It’s best to think of an interest rate as the cost of borrowing money.
• Interest rates compensate lenders for taking on a certain acceptable level of risk.
• Whether interest rates are high or low is largely dependent on the supply and demand of credit.

The relationship between lenders and borrowers

Whenever lenders agree to approve a loan, they take on a certain acceptable level of risk that the borrower may not be able to repay what they owe. For this reason, interest rates compensate the lender for taking on this risk.

Along with this risk of loan default, there is also the risk of inflation to consider. If you were to lend someone some money today, there is a risk of the price of goods and services going up by the time you are paid back the full amount, meaning that even though you get every cent of what you’re owed, inflation may have risen during the repayment period, decreasing your purchasing power on the original loan amount. In this way, lenders use interest rates as protection against future increases in inflation.

As a borrower, you also pay interest as the price for gaining access to the funds you need now, instead of later. We all know that to save the full amount to buy a median property in Australia would take so long that there may be little time left to enjoy it once you finally got the keys.

Why do interest rates change?

Supply and demand

Whether interest rates are high or low is largely determined by the supply and demand of credit. If there is more demand for credit, interest rates will generally increase. If demand for money or credit drops, generally so do interest rates. At the same time, if the supply of credit suddenly spikes, interest rates will generally fall, and a decrease in supply of credit will generally see interest rates go up.

Lenders increasing the amount of money they are willing to lend to borrowers raises the supply of credit. When you open a bank account, depending on the type of account, your bank will then use money you deposit for lending out to other customers. This means that the more money customers keep in their bank accounts, the more their banks can lend out, and higher amounts of credit are made available to the economy. As this happens, the price of borrowing (or, interest rates) decreases.

As lenders and borrowers decide to defer the repayment of their loans, credit available in the economy decreases. Say, for example, you decided to put-off repaying your credit card or home loan this month, or for a couple of months. By doing so, you not only increase the amount of interest you’ll have to pay back over time – you’re decreasing the amount of available credit. As a result, interest rates will rise.

Inflation

Another factor that influences interest rates increasing of decreasing is inflation. If the inflation rate is rising, interest rates are more likely to rise, and in the rare event that inflation may be falling, interest rates are likely to decrease.

The main reason lenders will raise interest rates in line with rising inflation is to protect themselves financially against the decrease in purchasing power they may experience as a result of having loans repaid over a long period of time.

Greater Bank

Many borrowers will remember periods of higher inflation during the 1970’s and 80’s, and as a result, the corresponding higher interest rates lenders charged to make lending money worthwhile. As inflation dropped, however, so did interest rates.

Within Australia

In Australia, the direction of interest rates is largely determined by the Reserve Bank of Australia (or RBA). The RBA states that it takes a number of factors into consideration when making monetary policy decisions. These include inflation, unemployment, wage growth, household debt, the Australian Dollar, overseas demand and the consumer confidence index.

Let’s examine a couple of these factors in detail.

• Household debt - Whether of not household debt levels are high is a determining factor for the RBA in the direction of interest rates up or down. As so many Australians have borrowed large amounts for their home, this will need to be taken into account as any significant rise in interest rates will affect households profoundly.
• Unemployment - If the RBA sees unemployment as being too high, there is a higher probability they will cut interest rates. This is so businesses can expand further and create jobs.
• The Australian Dollar - The RBA monitors the Australian dollar and adjusts the interest rate in accordance to how the exchange rate is performing.
• Consumer Confidence Index - The RBA will look at this index as an indicator of the level of optimism consumers feel about their personal financial situation.

Summing Up

For most of us, as individual borrowers or investors, the direction of interest rates holds significant sway over our quality of life. If lending rates are too high, as borrowers this may make it difficult for us to access credit, or put financial strain on our budget in order to keep meeting our repayments. By paying attention to some of the key indicators outlined above, it may be possible for you to be able to read the signs ahead of time and be prepared for significant interest rate fluctuations.