How to Select a Lender Part 4: Interest Rates Expanded

Part 4: Interest Rates Expanded

In Part 3, we discussed what interest rates are, the ins and outs of how they are calculated, and how they work. This knowledge is useful on its own, but in order to get the most out of it, we have to understand a little more about how lenders look at interest rates from their point of view, what our options are and how to choose the best loan structure for our individual situation.

How do banks decide on interest rates?

• This has been partly discussed in Part 3, but in addition, it’s important to understand how lenders determine the risk profile of a given loan scenario. Let’s think about things like a lender. They want to achieve two goals when they lend money:

  • Get their money back

  • Make money on top

• In order to determine whether they will get their money back, lenders need to work out whether the customer can repay their loan or not, and what happens if they can’t. Most often, with a mortgage, this is determined by the value of the property, as that is what the lender will be able to sell to get their losses back. Therefore, if the bank were to lend 100% of the value of the property, it would be risky as if the property decreased in value, the bank would lose money if the customer can’t repay their loan. Therefore, the customer is usually required to put down a deposit to reduce the risk for the lender, and that’s where the 20% deposit on a home amount comes from - 80% of the value of the property is the maximum value that most lenders will deem acceptable from a risk point of view. Some lenders will charge mortgage insurance or lend in alternative ways, but this is the most common scenario.

• In order to determine whether the money will be made on top, lenders need to work out the risk. If the risk of the customer not being able to repay their loan is larger, or the lender has contributed a large percentage of the value of the property, then the lender needs to charge more on top to make up for the additional risk and therefore make it worthwhile to lend out the money. This is where they will add to the interest rate.

How do we decide on fixed or variable interest rates? What are the potential pitfalls associated with them?

• Fixed interest rates have both pros and cons.

  • Pros:

    • A stable interest rate with stable repayments irrespective of market conditions

    • Most lenders can fix for 1-5 years

    • After the fixed term expires, the consumer can re-fix, refinance, or continue as variable

    • In the current market - can often get a 1-2 year fixed rate that is lower than the variable rate

  • Cons:

    • If you need to sell your property or want to change your interest rate to a variable interest rate because rates have dropped, the lender will charge a break cost - proportional to loan value, fixed-term remaining and difference between current variable rate and the fixed rate

• Variable rates also have their fair share of pros and cons:

  • Pros:

    • Flexible option - can refinance, fix rate or move securities (not all lenders) at will

    • Often can come with additional perks, such as offset accounts

  • Cons: 

    • Vulnerable to fluctuations in the market 

    • Often slightly higher than the lowest fixed rate

How do we differentiate interest-only repayments and principal and interest? 

• The other major component in deciding on a loan structure is whether to choose principal and interest repayments or interest only.

• We have a blog article devoted to this topic - P&I vs Interest Only

• For any further questions, feel free to contact Lite Financial at any time. 

In summary, before deciding on a loan structure, the most important thing is to understand your goals and objectives. A first home buyer might want to retain the home they fought hard to buy for upwards of 20 years, so a 5 year fixed rate might give them peace of mind which they value more than saving a few dollars. Conversely, a seasoned investor might want to go for a 1-year fix with interest-only repayments to take advantage of a lower interest rate in the short term, while knowing that they will be selling their property 1.5 to 2 years down the line. If you would like more information or advice to suit your personal situation, contact Lite Financial for a free consultation. We have the experience and knowledge to support you in your financial journey.