You may have seen mortgage interest rates advertised on lenders websites or sites like RateCity and wondered how they are set and how you can get a better deal.
Usually lenders will set a benchmark rate, which is called the standard variable rate. As the name suggests, it’s the general rate on offer to mortgage customers. However, lenders often offer various discounts on the standard variable rate depending upon the borrower’s characteristics. Being aware of the factors affecting your mortgage rate may help to position yourself as an ideal borrower in the eyes of the lender and to score a rate reduction.
What determines your mortgage interest rate?
Suppose you applied for a mortgage with a lender that follows risk-based pricing. In that case, it’s natural that a borrower with a low risk profile will be considered to receive a larger discount. In other words, all else being equal, someone with a high credit score is likely to secure a lower mortgage interest rate than someone who has an average credit score. But there are other indicators of how much of a risk you may pose to lenders that tend to affect your mortgage rate, including your loan-to-value ratio (LVR), your property’s location, your other assets and the type of income you earn.
By understanding the factors that determine your mortgage rate, you can time your application to when you meet lenders’ discount criteria, shop around for a mortgage more confidently and make an informed choice. You may also decide to make some changes in your personal and financial life, like developing a regular saving habit or working towards a better credit score, to increase your chances of negotiating a better discount on your home loan interest rate.
Factors affecting mortgage rates for home buyers generally
One common factor that tends to affect the mortgage rate is the official cash rate set by the Reserve Bank of Australia (RBA). The official cash rate is the market rate on overnight loans between financial intuitions. To manage the economy, especially inflation, the RBA may raise or cut the official cash rate by a measure of basis points.
Lenders tend to move in the direction of the changes in the rate cut. This means that mortgage interest rates tend to increase and drop each time there’s a rise or cut in the official cash rate, respectively.
However, lenders don’t necessarily have to follow the cash rate when setting their interest rates. Having said that, a bank that fails to pass on the cash rate cut to its customers might earn a bad reputation and risk losing customers. As a result, there is pressure on lenders to follow the official cash rate when determining their standard variable rates.
Factors affecting individual mortgage rates
In addition to the RBA’s cash rate, there are a few factors that may influence the interest rate offered to individual borrowers.
1. Loan-to-value ratio
The loan-to-value ratio refers to the percentage of a property’s value that a financial institution will let you borrow for a home loan. For example, if a lender requires a loan-to-value ratio of 80 per cent, it means that you’ll have to come up with 20 per cent of the total value of the property to be approved for this home loan. Generally, an LVR of 80 per cent or less is considered lower risk by lenders for most standard types of home loans.
If your LVR is over 80 per cent, you’d be typically required to pay lenders’ mortgage insurance (LMI) to reduce the risk to the lender. An LMI premium can potentially add thousands of dollars to your home loan amount. Even with LMI, high LVR loans are considered riskier and you might end up paying a slightly higher interest rate when you apply for a home loan with less than 20 per cent deposit.
Even if you find that you are being offered a comparable rate with a lower deposit, bear in mind that you’ll have to pay the LMI premium, which will increase your overall borrowing cost over the life of the loan.
2. Your mortgage size
According to an RBA publication, borrowers applying for larger loans have traditionally attracted sizeable discounts from lenders. According to the example quoted, a borrower with loan approval for $1,000,000 may attract a 12-basis-points larger discount than a smaller sized loan of $400,000 with comparable characteristics.
It’s suggested that borrowers seeking larger loans likely have more bargaining power to negotiate larger discounts. Furthermore, lenders are sometimes more willing to offer greater discounts on larger borrowings, owing to the fixed costs associated with writing loans, irrespective of the size.
3. Your credit score
Your credit score is an important factor used by lenders to predict how reliable you might be in paying down your home loan. Your credit score is calculated based on your credit report, which is a comprehensive record of your financial history. If you have been paying your bills regularly and making all your debt repayments in a timely fashion, you are likely to have a high credit score, making you a low-risk borrower in lenders’ eyes.
On the other hand, if you’ve defaulted on your payments in the past or don’t have much of a credit history, your score may be low. Depending on the lender you apply with, a low score can potentially derail your mortgage application or you might end up paying a higher interest rate on your mortgage.
If you’re planning to apply for a home loan, it may be worthwhile to pull out your credit report online and double-check it for any errors that might be reducing your credit score and preventing you from qualifying for better interest rates. If you find any errors, dispute them immediately to have them removed from your file.
If you have made mistakes in the past but your finances are back on track and you think you can afford a mortgage, you may consider speaking with a broker to apply for a home loan with low credit.
4. Other factors impacting your home loan
Several other variables impact your mortgage interest rate, but may have a smaller effect than those listed above. For instance, some lenders might offer slightly different interest rates depending on where your house is situated.
The type of loan also tends to make a difference. Construction loans often receive smaller discounts compared to home loans secured against existing properties. Additionally, if you are a self-employed individual without proper documentation to prove your income, you might be eligible for a low doc loan that is usually associated with a higher interest rate compared to a standard mortgage loan.
Your mortgage interest rate also varies according to the type of property. Investment loans tend to attract higher interest rates than owner-occupied loans, as lenders typically view investors as higher risk borrowers.
Even the term of your loan can impact its interest rate. Generally, short term loans come with lower interest rates, but the monthly repayment might be higher owing to the shorter timespan for paying back the loan. That’s because your monthly repayment amount is calculated using several factors, including your loan amount, interest rate, and term. You may use an online calculator to crunch the numbers and see how your monthly repayments change as you vary the term of your home loan.
Comparing home loan rates: What you should keep in mind
There are multiple factors affecting your mortgage rate, but all lenders have slightly different methods in place to assess your mortgage application. It is generally considered prudent to shop around and compare home loans from multiple lenders, before choosing one that is right for your needs.
Keep in mind the cheapest home loan might not always be the right home loan for your situation. Besides the home loan interest rate, it is sometimes worth considering any additional features that could help you in meeting your long term goals, even though you might end up paying slightly extra for them.
You can also connect with a mortgage broker to navigate the mortgage market’s complexities with confidence and ease. A good mortgage broker can help you find home loans with affordable interest rates and features to meet your long term financial goals, as well as negotiate with lenders on your behalf to potentially secure you a competitive deal.