Making sense of the rate cuts, what does it all mean?

Making sense of the rate cuts, what does it all mean?

The two recent Reserve Bank (RBA) interest rate rate cuts and subsequent rate changes by lenders around Australia have dominated the media headlines in recent weeks. What does it mean for you?

If you haven’t studied finance, and are currently comparing home loans, you may not be able to make sense of everything. Between recent changes to cash rates, interest rates, serviceability and sensitivity buffers, does the news leave you up the creek without a paddle?

Not necessarily.

From everyday Australians to property developers and business owners, these possibly unfamiliar terms surrounding the rate cuts have sparked a nationwide conversation, and this warrants an explanation of these changes in layman’s terms.

What do the Reserve Bank rate cuts mean, and how will they affect your borrowing power?

It’s probably best to start this from the beginning, because this can get a little complicated. First, let’s talk about the Reserve Bank, also known as the RBA. 

home-loans-reserve-bank-rate-cuts

What is the Reserve Bank of Australia (RBA)?

The RBA is a government owned and operated agency that controls the monetary policy in Australia. The Reserve Bank Board meets eleven times a year, on the first Tuesday of every month, to set a ‘cash rate.’

What is the cash rate and why does the RBA change it?

The RBA is a body corporate with a duty to contribute to the stability of the currency, and economic prosperity of the Australian people. The cash rate is an interest rate that was created as a tool to manage inflation.

The Reserve Bank uses the cash rate to:

1. Determine the interest charged on overnight loans between banks
2. Set a financial benchmark for interest rates in the market, impacting both borrowers and savers
3. Stimulate or dampen consumer spending and inflation, to boost the Australian economy

What is inflation and how does that affect the cash rate?

Inflation is best explained as the percentage change in the price of goods and services that households buy over time. If you’re a visual learner, it may be best to look at the Consumer Price Index (CPI) to get an idea of how the inflation rate has changed in the past century.

The Reserve Bank’s target inflation rate is 2 to 3 per cent, and the current inflation rate as of 24th July 2019 is 1.3 per cent.

As such, the recent cuts have been made to encourage banks and lenders to reduce their current interest rates, so as to boost consumer spending, and increase the overall inflation rate.

What is serviceability, and how do banks calculate it?

You may have also read amongst the RBA rate cut headlines, that a new Australian Prudential Regulation Authority (APRA) ruling has meant banks are changing their home loan serviceability assessments and policies.

Serviceability is a banking term used by lenders to describe the ability of the borrower to meet loan repayments. This is calculated based on the borrower’s income, expenses, loan amount and other monetary commitments to generate an overall figure; the debt service ratio.

The maximum debt service ratio typically ranges between 70-90 per cent, but borrowers need to be aware that lenders can add a sensitivity buffer to the serviceability assessment rate, to ensure borrowers keep up with repayments.

Prior to 5th July 2019, APRA — the independent statutory authority that supervises institutions across banking — enforced a standard 7 per cent interest rate floor on home loan serviceability assessments. This meant that lenders would assess your ability to repay a home loan on an interest rate of 7 per cent, not based the advertised rate of the loan.

However, after the first RBA cash rate cut in June, APRA has removed the standard interest rate floor, and lenders are now able to set their own minimum interest rate floor for use in serviceability assessments, with revised sensitivity buffer of at least 2.5 per cent over the loan’s advertised interest rate.

What impact do interest rate floors and buffers make on borrowers?

Business, finance, saving money, banking, property loan or mortgage concept :  Wood house model, coins, eyeglasses and saving account book or financial statement on office desk table

Let’s see this in action…

Say you’re applying for a $500,000 home loan. The advertised home loan rate is 4.72 per cent, the interest floor rate is 6 per cent and the sensitivity buffer as standard is 2.5 per cent.

The bank will determine your ability to make your loan repayments on either one of two rates:

1. The serviceability / interest rate floor (6 per cent)
2. The advertised loan’s interest rate plus the sensitivity buffer (4.72 + 2.5 = 7.22 per cent)

The key thing to remember here is, you will pay whichever rate is higher.

To make this easier to understand, here are five different examples of how lenders assess your ability to make repayments, determining the amount of money you will be able to borrow.

It’s rare that you will ever pay the interest floor rate advertised by lenders at present, as shown by the example above, and those we have included below.

Lender

Advertised Interest Rate

Sensitivity Buffer Rate

Advertised Rate + Buffer (a)

Interest Rate Floor (b)

The interest rate that will be used to calculate your repayment ability*

CBA

3.45%

2.5%

5.95%

5.75%

5.95%

NAB

3.35%

2.5%

5.85%

5.50%

5.85%

Macquarie

3.24%

2.5%

5.74%

5.30%

5.74%

Westpac

3.48%

2.5%

5.98%

5.75%

5.98%

ANZ

3.38%

2.5%

5.88%

5.50%

5.88%

*Notes: There may be additional fees that apply to your home loan, such as establishment fees, Lenders Mortgage Insurance (LMI) and other charges.

Data accurate as of 24th July 2019

What to look out for…

If you’re currently looking to make the ‘Great Australian Dream’ of owning a house come true, you need to be aware of the complexities of home loans.

Home-loans-rates-rba-apra-2019

Interest rates, sensitivity buffers, fees, and charges can create an unexpected financial burden if not carefully reviewed.

As with all financial decisions, the “best” home loan for you will depend upon your specific situation, financial circumstances and spending habits. Looking only at interest rates, fees, and charges may not give you the entire picture, so you need to do your research by either speaking directly to the lender or engaging a mortgage broker to help you.

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What happens to my home loan when interest rates rise?

If you are on a variable rate home loan, every so often your rate will be subject to increases and decreases. Rate changes are determined by your lender, not the Reserve Bank of Australia, however often when the RBA changes the cash rate, a number of banks will follow suit, at least to some extent. You can use RateCity cash rate to check how the latest interest rate change affected your mortgage interest rate.

When your rate rises, you will be required to pay your bank more each month in mortgage repayments. Similarly, if your interest rate is cut, then your monthly repayments will decrease. Your lender will notify you of what your new repayments will be, although you can do the calculations yourself, and compare other home loan rates using our mortgage calculator.

There is no way of conclusively predicting when interest rates will go up or down on home loans so if you prefer a more stable approach consider opting for a fixed rate loan.

What is a comparison rate?

The comparison rate is a more inclusive way of comparing home loans that factors in not only on the interest rate but also the majority of upfront and ongoing charges that add to the total cost of a home loan.

The rate is calculated using an industry-wide formula based on a $150,000 loan over a 25-year period and includes things like revert rates after an introductory or fixed rate period, application fees and monthly account keeping fees.

In Australia, all lenders are required by law to publish the comparison rate alongside their advertised rate so people can compare products easily.

What is a variable home loan?

A variable rate home loan is one where the interest rate can and will change over the course of your loan. The rate is determined by your lender, not the Reserve Bank of Australia, so while the cash rate might go down, your bank may decide not to follow suit, although they do broadly follow market conditions. One of the upsides of variable rates is that they are typically more flexible than their fixed rate counterparts which means that a lot of these products will let you make extra repayments and offer features such as offset accounts.

What is a standard variable rate (SVR)?

The standard variable rate (SVR) is the interest rate a lender applies to their standard home loan. It is a variable interest rate which is normally used as a benchmark from which they price their other variable rate home loan products.

A standard variable rate home loan typically includes most, if not all the features the lender has on offer, such as an offset account, but it often comes with a higher interest rate attached than their most ‘basic’ product on offer (usually referred to as their basic variable rate mortgage).

What is the difference between fixed, variable and split rates?

Fixed rate

A fixed rate home loan is a loan where the interest rate is set for a certain amount of time, usually between one and 15 years. The advantage of a fixed rate is that you know exactly how much your repayments will be for the duration of the fixed term. There are some disadvantages to fixing that you need to be aware of. Some products won’t let you make extra repayments, or offer tools such as an offset account to help you reduce your interest, while others will charge a significant break fee if you decide to terminate the loan before the fixed period finishes.

Variable rate

A variable rate home loan is one where the interest rate can and will change over the course of your loan. The rate is determined by your lender, not the Reserve Bank of Australia, so while the cash rate might go down, your bank may decide not to follow suit, although they do broadly follow market conditions. One of the upsides of variable rates is that they are typically more flexible than their fixed rate counterparts which means that a lot of these products will let you make extra repayments and offer features such as offset accounts.

Split rates home loans

A split loan lets you fix a portion of your loan, and leave the remainder on a variable rate so you get a bet each way on fixed and variable rates. A split loan is a good option for someone who wants the peace of mind that regular repayments can provide but still wants to retain some of the additional features variable loans typically provide such as an offset account. Of course, with most things in life, split loans are still a trade-off. If the variable rate goes down, for example, the lower interest rates will only apply to the section that you didn’t fix.

What is a honeymoon rate and honeymoon period?

Also known as the ‘introductory rate’ or ‘bait rate’, a honeymoon rate is a special low interest rate applied to loans for an initial period to attract more borrowers. The honeymoon period when this lower rate applies usually varies from six months to one year. The rate can be fixed, capped or variable for the first 12 months of the loan. At the end of the term, the loan reverts to the standard variable rate.

What is the best interest rate for a mortgage?

The fastest way to find out what the lowest interest rates on the market are is to use a comparison website.

While a low interest rate is highly preferable, it is not the only factor that will determine whether a particular loan is right for you.

Loans with low interest rates can often include hidden catches, such as high fees or a period of low rates which jumps up after the introductory period has ended.

To work out the best value for money, have a look at a loan’s comparison rate and read the fine print to get across all the fees and charges that you could be theoretically charged over the life of the loan.

What is the difference between a fixed rate and variable rate?

A variable rate can fluctuate over the life of a loan as determined by your lender. While the rate is broadly reflective of market conditions, including the Reserve Bank’s cash rate, it is by no means the sole determining factor in your bank’s decision-making process.

A fixed rate is one which is set for a period of time, regardless of market fluctuations. Fixed rates can be as short as one year or as long as 15 years however after this time it will revert to a variable rate, unless you negotiate with your bank to enter into another fixed term agreement

Variable rates is that they are typically more flexible than their fixed rate counterparts which means that a lot of these products will let you make extra repayments and offer features such as offset accounts however fixed rates do offer customers a level of security by knowing exactly how much they need to set aside each month.

Interest Rate

Your current home loan interest rate. To accurately calculate how much you could save, an accurate interest figure is required. If you are not certain, check your bank statement or log into your mortgage account.

Mortgage Calculator, Property Value

An estimate of how much your desired property is worth. 

What is a building in course of erection loan?

Also known as a construction home loan, a building in course of erection (BICOE) loan loan allows you to draw down funds as a building project advances in order to pay the builders. This option is available on selected variable rate loans.

What is an ombudsman?

An complaints officer – previously referred to as an ombudsman -looks at formal complaints from customers about their credit providers, and helps to find a fair and independent solution to these problems.

These services are handled by the Australian Financial Complaints Authority, a non-profit government organisation that addresses and resolves financial disputes between customers and financial service providers.

What is a specialist lender?

Specialist lenders, also known as non-conforming lenders, are lenders that offer mortgages to ‘non-vanilla’ borrowers who struggle to get finance at mainstream banks.

That includes people with bad credit, as well as borrowers who are self-employed, in casual employment or are new to Australia.

Specialist lenders take a much more flexible approach to assessing mortgage applications than mainstream banks.

Monthly Repayment

Your current monthly home loan repayment. To accurately calculate how much you could save, an accurate payment figure is required. If you are not certain, check your bank statement.