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How to plan for an interest rate rise

How to plan for an interest rate rise

It’s very unlikely that you’ll be paying the same interest rate on your home loan over its full decades-long term. So how can you plan ahead to keep your household budget under control the next time rates rise? 

Why do interest rates rise?

Banks and mortgage lenders set their interest rates on home loans and other financial products based on a wide range of different economic factors, from the national cash rate set by the Reserve Bank of Australia (RBA) to the cost of overseas funding. When it starts to cost banks more to provide customers with financial products and services, they often pass on these costs to borrowers in the form of higher variable interest rates.

What if I have a fixed interest rate?

Fixing your interest rate for a limited time can lock in your mortgage repayments for the duration of the fixed term (often between one and five years). Whether your lender raises or lowers its interest rates, your repayments will stay the same, making managing your household budget that little bit simpler.  

However, once your fixed rate term comes to an end, you may have the option to re-fix your loan for another term, or your loan will revert to a variable interest rate. This revert rate may be higher than the fixed rate you were paying, and could rise even higher in the future.

How can I prepare for an interest rate rise?

Calculate your future costs

While you may not be able to predict exactly how much interest rates may rise and when they will start increasing, you can crunch some numbers to help estimate your future costs. 

RateCity’s mortgage calculator can help you estimate your home loan repayments in the event of an interest rate rise. Consider testing a few different scenarios and comparing the repayments to your household income to see if you’re likely to end up in mortgage stress.

You can also use the calculator on RateCity’s RBA Rate Tracker page to estimate how your home loan repayments could change if the RBA adjusts the national cash rate by 25 or 50 basis points.

Take steps to shrink your interest payments

Finding ways to lower or offset your mortgage principal can help reduce the interest that’s charged on each repayment, which may be able to help you absorb the impact of a rate rise.

Making extra repayments can help to lower your principal, bringing you closer to paying off your mortgage ahead of schedule. If you’re concerned about putting too much of your spare cash into your mortgage, find out if your home loan has a redraw facility – this will let you access any extra repayments previously made onto your mortgage if you need the money to manage future expenses. Keep in mind that some banks limit the number of redraws you can make or the amount you can redraw, and may charge redraw fees.

Keeping your money in an offset account is another flexible option that could help you to save on interest. This bank account is linked to your mortgage, so that any money deposited here can “offset” you mortgage balance. For example, If you have $350,000 left on your home loan, and $50,000 saved in an offset account, you’ll pay interest as if you only owe $300,000. You can also transfer and withdraw this money if you need it as easily as with any other bank account, making it easier to access your cash if you need it than using many redraw facilities.

Plan to refinance your mortgage

If your mortgage lender is raising its interest rates more than you’d like, or more than you can comfortably afford, you may be able to look at refinancing to a different home loan, possibly with another lender. Switching lenders could let you enjoy a lower interest rate, lower fees, or more flexible home loan features and benefits, which could help you manage your repayments.

This option may not be practical or cost-effective for everybody – switching home loans may involve paying fees to one or more lenders, and if you’re still on a fixed rate there may be break fees to consider. Additionally, you’ll need to fulfil the new lender’s eligibility requirements, which may include holding a minimum amount of equity in your property.

Factor interest rate rises into your budget

Before a bank or mortgage lender will approve a home loan application, they’ll want to be confident that you can afford the repayments. Not only will they calculate if you can afford the repayments given the loan’s interest rate and your current income and expenses, but they’ll also calculate the repayments using a buffer to represent potential future rate rises. 

Banks and mortgage lenders set their own “floor rates” and don’t make them publicly available, but floor rates of around 5 per cent aren’t uncommon. A bank will often check your income and expenses against either their floor rate or your home loan’s interest plus an extra 3 per cent buffer (formerly 2.5 per cent) – whichever is higher.

Before you apply for a home loan, you may be able to get a better idea of how a potential lender may see you by adding an extra 2.5 or 3 per cent to the mortgage’s advertised interest rate and running the numbers through a mortgage calculator. RateCity’s How Much Can I Borrow calculator already includes a similar buffer in its calculations to help estimate the maximum amount a bank may offer to lend you.

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This article was reviewed by Personal Finance Editor Alex Ritchie before it was published as part of RateCity's Fact Check process.

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