I’d like to say we’re almost done with home loans but if I did I’d be lying. There’s so much complexity out there on this topic and it has such a profound impact on your cash flow that I think everyone has a right to know as much as possible before taking the plunge. So without further ado, let’s make fun of birkenstocks and the people who wear them.
Variable rate home loans
The majority of home loans in Australia are based on a variable home loan rate. What this means is that your home loan’s interest rate may be moved up or down at your lender’s will. Why would a lender lower your interest rate?
- Changes to a central bank’s target interest rate: In Australia we call this the RBA’s cash rate target. It’s currently sitting at 0.10% and unless the RBA is willing to tip into negative territory, there’s very little room for further RBA cash rate cuts. The RBA lowers the cash rate when they’re looking to stimulate the economy and increases the cash rate when the economy is running too hot and there’s risk of inflation and asset bubbles (check out Economics 101 for more on this). Now keep in mind that your lender is not actually obligated to lower its interest rates simply because the RBA cuts the cash rate. Although, not doing so may mean your lender will lose customers to competitors that do lower their interest rates. It also attracts quite a bit of sass from the federal government despite the fact that we actually live in a capitalistic society which has (for the most part) adopted a free markets ideology – hey yo Frydenberg I’m talking to you.
- Quantitative easing: This is something that a central bank might whip up when its war chest that is its target interest rate has little-to-no room to move but they still need to stimulate the economy because of idk a pandemic that nobody anticipated (except for the Bush administration, the Obama administration, Bill Gates, The World Health Organisation and countless infectious disease experts). We don’t need to go into too much detail but quantitative easing loosely translates to a central bank lending to the government by buying government bonds. The RBA has been doing a fair bit of this lately and because so many financial products are priced using a “risk-free rate” tied to yields on government bonds, interest rates have generally been falling as a result.
- Term Funding Facility: This is new and is about to expire. In response to the covid-19 pandemic, the RBA announced the Term Funding Facility (TFF) to encourage lending and stimulate the economy. The idea was that lending would help keep mortgage costs low and help businesses stay in business. Through the TFF, the RBA lends money to commercial banks at super affordable rates (0.1-0.25%) which banks can then use to on-lend to ordinary people and businesses at more commercial rates. The TFF has helped bring down interest rates across the board but is due to expire on 30 June 2021.
- Competition: Fortunately, there are now a myriad of small bank and non-bank lenders out there to challenge the tight grip the big 4 banks once held. Unfortunately, the big banks are quickly acquiring them. But in the meantime, their presence is forcing the hand of the market generally and lenders are finding themselves forced to cut rates at times when they don’t want to or else risk losing valuable market share.
Why would you opt for a variable rate home loan? Well the primary reason is that you may think rates have further room to fall. Another reason is that fixed rates at the time you take out your loan might be higher than variable rates (this is usually the case – the current home loan environment is a rarity) and you’re not concerned about rising interest rates. Or you might have a variable rate home loan because you have an offset account attached to your mortgage and fixed rates don’t often come with offset accounts (more on this in a later article).
Fixed rate home loans
Fixed rate home loans used to be quite unappealing and quite unpopular in Australia. Until the pandemic happened. A fixed rate home loan essentially means you agree upfront to pay your lender a set interest rate for a set period of time. Subject to paying expensive break fees, you are pretty much stuck with that interest rate for that set period of time, despite whatever happens to interest rates in the market in the interim. You can see how taking out a fixed rate home loan is effectively placing a bet: you are betting that during the term of your fixed rate period, interest rates will not come down by any substantial degree.
Why would you opt for a fixed rate home loan? The primary reason is certainty – you know how much you need to set aside every month to make your mortgage repayments and you can budget and prepare for this in advance. It also happens to be cheaper right now. Fixing your rate on a 600k loan at 0.5% less than a variable rate home loan will save you around 3k per year before fees. Imagine all the cool new kicks you could buy every year, or birks if your taste in fashion is absolutely ghastly. Usually fixed rates are higher than variable rates but during the covid-19 pandemic lenders hardly touched variable rate home loans despite a lot of downward pressure on interest rates from the RBA, instead opting to lower fixed rates for new customers.
Where are interest rates going? Well I have no idea. Nobody does to be fair. If I knew where rates were going I’d be well placed to save quite a bit of money myself. For what it’s worth, the RBA has signaled to the market that it’s hesitant to raise the cash rate until 2024 unless something big happens (ie sustained inflation, wage growth or a dramatic drop in unemployment). The all-seeing eye that is the bond market predicts otherwise (more on that in a later article).
Hybrid home loans
Haven’t quite made up your mind? Well you can actually take out a hybrid home loan that is both variable and fixed. How it works is that you nominate to your lender that (for example) you would like 50% of your loan amount to be variable and the other 50% to be fixed. This means that if you fix your rate and interest rates fall further, you can still take advantage of lower interest rates on half your loan (through the variable component of your loan). By doing this you are minimising your risk.
There’s also another reason why people take out hybrid home loans but it’s a little complex. Many people like mortgage offset accounts but they are generally pretty uncommercial products (ie they come with higher interest rates). They’re also much more likely to come with variable interest rate home loans than fixed rate home loans. Some people like to take advantage of this hybrid offering by fixing (for example) 75% of their home loan with no offset account and apportioning a much smaller 25% of their home loan towards a more expensive variable home loan with an offset account.
To give you a rough idea of the spread between short-term fixed interest rates (no offset) and variable interest rates (with offset), fixed investment loans (no offset) are sitting around 2.25-2.5% and variable investment loans (with offset) are sitting around 3.75-4%. I know that doesn’t sound like much but trust me it’s a big difference when you’re talking about an 800k loan. A hybrid offering will allow the investor to only cop the higher interest rate on a small proportion of their loan while allowing the investor to park a fair chunk of their spare funds in that offset account.