Confused about interest rates?

Who sets the interest rate – or what interest rates you have to choose from?

Interest rates are loosely determined by the Reserve Bank of Australia (RBA).  It is responsible for following the developments in the Australian and international economies and financial markets.  Each month the RBA hold a meeting to examine the rate of inflation, unemployment, retail sales and other relevant information.  This information is used to set the interest rates.

How decisions are made

The RBA will increase interest rates if they feel the economic activity is too high.  To do this, they raise the official ‘cash rate’.  When interest rates rise, your mortgage repayments will increase and you will therefore reduce spending your money elsewhere.

Lenders borrow money, and then lend the money to you at an increased rate – therefore if the interest rate they pay increases, the interest rate you pay will also increase.

This obviously works in reverse also.  Interest rates will usually rise and fall in 1/4 of a percent increments (.25%).

When you borrow

When you borrow money from a lender, there are two interest rate options – fixed and variable.  You can choose either and in some cases a combination of both depending on the lender.

Variable rates

A variable interest rate will vary over the term of the loan as the name suggests.  So as the RBA increases or decreases the cash rate, the interest rate you pay will rise or fall accordingly.  Lenders are also able to increase or decrease the rate at any time independant to the RBA.  When the RBA changes the official cash rate, lenders are not under obligation to follow  – they can choose to pass on as much or little…or in some cases more than or none of the RBA increase or decrease.  A home loan with a variable interest rate is more flexible than that of a fixed rate.

Fixed interest

A fixed rate allows you to lock into an interest rate for a specific period of time over the term of the home loan.  One to five years is standard for most lenders, with some offering up to 15 years.  

The benefits to a fixed home loan is the certainty in home loan repayments – for those who like to security of knowing exactly what they have to budget for over the next few years.  Also if the interest rates rise, the interest you are charged on your home loan will not, and therefore your repayments will remain the same.

The detrements or cons to a fixed rate is if interest rates fall, you are stuck with the rate you locked into.  Fixed rate home loans are generally less flexible, however in recent times lenders have become more and more flexible.  The other negative is that there are usually break costs should you pay out your home loan, or make a large lump sum repayment.

Time to decide

In order to take advantage of the flexibility of the variable rate, and the security of a fixed rate, some people choose a combination of both, commonly known as a split home loan facility.

It is important to choose a home loan product suited to your individual needs.  Although it is possible to switch from a variable to a fixed home loan product this may attract a fee. 

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