2. Home Owners

Introduction

When you apply for a loan, you often have the opportunity to select a loan with a variable interest rate or one with a fixed interest rate, either in part or in full.

A variable interest rate can change over time as determined by the lender. With a Fixed Rate, the rate of interest is set for a period of time, often from one to five years. A lender will often offer a borrower the opportunity to have part of their loan balance at a Variable Rate and the remainder at a Fixed Rate. This is known as a Hybrid Rate Loan.

What causes a lender to change their Variable Rate?

Most often, a change to the Variable Rate will follow a change by the Reserve Bank’s Official Cash Rate (OCR).

More recently, lenders are often seen to be taking into account other factors such as the cost of the funds a lender pays to borrow from overseas institutions. Unfortunately, for this reason, lenders (led by some of the Big 4) sometimes do not pass on the full rate reduction suggested by the downward movement of the OCR.

Do Variable Rates and Fixed Rates ‘follow’ each other up and down?

Generally, variable and Fixed Rates tend to mimic each other in terms of overall movement but many factors can lead to variations between the two. And to make it even more confusing, sometimes Fixed Rates are higher than Variable Rates and sometimes they are lower.

The factors which come into play include expectations of future interest rate movements (both locally and overseas) plus movements in the wholesale interest rates market, both locally but often overseas, from where a lot of a lender’s funds may be sourced.

So, the discrepancy between the two rates and whether Variable Rates are lower or higher than Fixed Rates is not a simple equation. In fact, it is quite complicated and convoluted and certainly not transparent!

Variable Rates

Features

– The interest rate may go up and/or down during the term of your loan. Generally, it will not vary more than once a month, if at all.

Pros of Variable Rate loans

– More loan features which may give you greater flexibility.

– You can make early repayments or pay off your loan sooner (including refinancing with another lender) without paying break costs. As noted earlier, break costs are those costs charged by a lender to a borrower when the borrower wishes to terminate a Fixed Rate loan before the expiry date of the loan term (often arising when the borrower wishes to sell their home).

– Some Variable Rate loans act as a continuous line of credit. This means you can access any available funds if you need money for something else later on (but there may be fees for this).

Cons of Variable Rate Loans

– Your repayments fluctuate with the current Variable Rate, so you don’t have as much certainty and may end up paying more interest than you planned (but also note: ‘the rate may go down as well so you save money’). And, as noted above, the movement in the rate is based on conditions outside your control.

– The uncertainty over repayments can make budgeting harder. This can be particularly relevant in the first few years of your loan as your income is unlikely to change significantly during this time.

– The flexibility and extra loan features can come at the cost of a higher interest rate. For example, some ‘low rate’ loans have limited features and may even have restrictions as to what you can do and when you can do it.

Fixed Rates

Features

– Fixed rate loans are generally fixed for a period, typically years.

– Most Fixed Rate terms are from one to five years. Not all lenders and not every lender’s products will offer every variability within this timeframe.

– At the end of the Fixed Rate term, your rate reverts to the current variable loan rate from your lender.

Pros of Fixed Rate Loans

– They make budgeting easier as you know how much you need to pay every month for the term of the Fixed Rate loan.

– The cost (interest rate) may be less as there are fewer features (e.g. redraw and offset may be non-existent or significantly reduced).

– You can set up automatic repayments for the term of the loan as the payments are fixed each month at the same amount.

– You can lock in a Fixed Rate when applying through a ‘rate lock’. This means if interest rates move up after you apply, but before settlement, you get the benefit of the Fixed Rate at the time you submit your application.

Cons of Fixed Rate Loans

– If rates go down, you won’t benefit from the rate reduction during the term of your loan.

– If you wish to pay off your loan sooner or refinance, there may be break costs or early repayment fees.

Hybrid rate loans

Features

– Part of your total loan is a Variable Rate loan with the balance being a Fixed Rate loan.

– You may choose to have part of your Fixed Rate loans for different time periods. For example: your total loan you apply for is $500,000. You choose to have $300,000 on a Variable Rate loan, $100,000 on a Fixed Rate loan, fixed for 1 year and $100,000 on a Fixed Rate loan, fixed for 3 years.

Our take

– No matter what the forecasters say about the future of interest rates, the reality is no one knows what is going to happen in the future. Even with all the known information available, there are still a number of unknown factors which can influence the amount and timing of any change in interest rates.

– So, all forecasters (and you) can do is make educated guesses as to the direction and timing of any changes.

– Other than any educated guess, the decision to either take a variable interest rate product or a fixed interest rate product is often a matter of 2 things to do with your feelings:1. Your feelings around adversity Vs missing out on something good:

1. Are you the sort of person who stresses if something adverse happens or are you the sort of person who stresses if you miss out on something good?

2. Your feelings around cashflow stress: are you the sort of person who stresses if your cashflow gets tight due to higher payments?

– Everyone is different and everyone’s appetite for risk is different so there is no ‘one answer is correct’ advice. And, when you are dealing with joint applicants, you need to take into account the risk profile of each applicant. Just because one applicant might be comfortable with a higher level of perceived risk, the other applicant might be a little bit more conservative; so you need to balance the attitudes of both applicants.

– As part of our due diligence when we assist you in identifying a suitable loan, we undertake a Needs Analysis for each person applying. We ask you on a scale of 1 to 10 what is your level of concern about rising interest rates?. We also ask you if you would like to consider a Fixed Rate loan, either in part or in full, and we go through with you all the features, pros and cons.

– We always ask ’Who is on your team?. What we want to know is, have you got a great team of advisors to assist you in making important decisions? Because when you are dealing with loans of hundreds of thousands of dollars, you need knowledgeable, ethical professionals advising you of your risks.

Below are some observations as reflected from the data obtained from the RBA for the 12-month period ending 31 August 2020. Whilst both the absolute numbers and the relationship between rates will change, these observations provide you with useful information when you are shopping for a home loan by explaining some of the macro risk profiles considered by lenders.

1. Principal and Interest (P&I) interest rates are generally lower than Interest Only (IO) interest rates. Based upon a quick look at two major lenders (Macquarie and Westpac), P&I rates are lower than IO rates by 0.7% pa and a whopping 2.25% pa respectively!!!

This spread in rates can change if lenders form a different view of future economic conditions including inflation. Right now, lenders are rewarding borrowers who can demonstrate a capacity to gradually repay their loan. (PS the sting in the tail for IO loans is that whilst the repayments might be lower (in dollar terms) than a P&I loan, the debt servicing rate for IO loans is higher than for P&I loans; the logic being that after the IO period ends, the loan principal needs to be repaid over a shorter period of time so the monthly repayments of the principal are higher).

2. Rates for Owner Occupiers (OO) are sometimes lower than the rates for Investors (IN). Currently, the Variable Rates for an Owner Occupier are about 0.3% pa lower than for a similar Variable Rate product for an Investor.

3. The relationship between variable rates and fixed rates is more complex. Depending upon lenders’ views of future interest rates (and a whole bunch of other economic factors), the Variable Rates can be higher or lower than the Fixed Rates. Currently, Variable Rates are lower than most similar Fixed Rate products. And, the difference in interest rates between the two increases as the Fixed Rate term increases (the lowest Fixed Rate term is 1 year and the highest Fixed Rate term is 5 years).

4. The Loan to Value Ratio (LVR) also impacts the interest rate you will pay. If you have an LVR of over 80%, you can expect to pay a premium of anywhere up to 0.5% pa (and perhaps higher). It is also worth noting that loans with a high LVR (mostly over 80% but sometimes a bit higher if, for example, you are an eligible borrower (e.g. medical practitioner)), also require borrowers to pay Lenders Mortgage Insurance (LMI). LMI is an insurance policy the borrower pays to protect the lender in the event of a default and is often capitalised on top of the loan amount. (Note: LMI also has some hidden costs to the borrower in the event of default but more on that elsewhere).

5. The size of the commitment suggests that lenders slightly favour loans under $1.0M over loans. However, the differential is not significant. – between nil and 0.1% pa.

[1] RBA Data: https://www.rba.gov.au/statistics/tables/#interest-rates

The marketplace for home loans

– The lending marketplace for consumers is large and confusing – particularly in the home loan and more broadly, the residential lending space (home loans and investment property loans).

– Apart from the big 4 retail banks (CBA, Westpac, NAB and ANZ), there are regional banks which operate in each State, credit unions and mutual lenders (which are ‘owned’ by consumers) plus the growing range of online ‘fintech’ lenders who only offer consumers loans via their website.

Brokers have access to many of these lenders plus even more as they can obtain loans from lenders who only lend money to consumers via a broker distribution channel.

– Research by KPMG[1] in 2019 indicates that the big 4 banks have a share of over 81% of the residential property mortgage market. And, as over 55% of borrowers use a broker[2], brokers also place a lot of their clients’ loans with the major lenders.

So, whether you use a broker or whether you walk down to your local high street bank, the big 4 dominate the lending landscape. Most borrowers probably feel that if they have a choice of 4 (or 5 or 6 if you include regional banks which are available in most States) of largest lenders, they would be getting an ‘ok’ deal – and that the options they are being offered by the big 4 represent what is available across the lending industry.

And for many borrowers, this might well be true – but it is not necessarily true.

The reason this approach of walking down your local high street is appealing to many borrowers who have not used a broker is because research has shown we don’t like too much choice. We do like choice, but not too much. And more than 4 or 5 to choose from quickly becomes ‘too much choice’.

So, with over 40 lenders which most brokers deal with, the choice is far too large to consider for most borrowers.

That is one of the main reasons why borrowers use a broker – to sort through the ‘too much choice’ factor quickly and efficiently so the borrower can approach a lender whose product is suitable for the borrower.

How do we shop for home loans?

The KPMG research shows a number of interesting facets in obtaining a loan:

– We prefer to research online (87% use and prefer the internet) but when it comes to the application, we are more likely to opt for face to face (56%) – but then, we prefer to revert to online service (80%). And, we really don’t like call centres and we try to avoid them whenever possible!!!

– 44% of those who have previously taken out a loan preferred to apply via a broker Vs 41% using their existing financier and 15% preferring to use a new financial institution.

– And of those who use a broker, 67% renegotiate their interest rates at least once every 5 years compared to 53% for those who applied directly to a lender. At BIR Solutions we do this every year with your existing lender and every 2 years with other lenders.

– The older we are, the more likely we are to use our existing lender.

– Roughly two thirds of respondents have 2 or more financiers.

– Reasons we choose brokers or new financial institutions – or decide to stay with our existing financier:

> Interest rate or price related data: 51% of those borrowers who used a broker channel and 59% of those who went to a new financial institution, did so for interest rate related reasons.

– and this was regarded as a significantly important reason. Only 19% of those who used their existing financier prioritized interest rate related reasons and they did not rank this reason as being an important reason for choosing their existing financier.

> Convenience: 35% of those borrowers who used a broker related channel and 65% of those who used their existing financier did so for convenience related reasons.

> Trust: was the third main area identified as reasons borrowers chose brokers (14%) or new financial institutions (27%) or they decided to stay with their existing financier (16%).

Based upon my exposure to borrowers, lenders and the broker channel, this research makes intuitive sense.

[1] Savings.com.au: Big banks lose market share in tough home loan environment by William Jolly

[2] The Adviser: Broker market share bounces back by Charbel Kadib

[3] Ibid To Sell is Human, Dan Pink p. 234

[4] Ibid, KPMG

[5] Subject to your consent – of course!

Before we start….

For further content, please visit https://www.bir.net.au/blog/

And, if you would like a Free Property Report, you can order yours here: https://www.bir.net.au/report-request. You can obtain a report for a particular property, suburb or region in Australia, so you can make informed property decisions. Plus, our suburb reports now provide a comparison report of up to 5 suburbs you want to research.

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Now, back to the Article! 😉

At its simplest level, there are 2 types of interest rate products available for the housing loan market in Australia – Variable Interest Rate products Vs Fixed Interest Rate products.

But this is just the start! Many lenders, for example, offer Fixed Rate products with different terms ranging from 1 year all the way through to 5 years.

And, there are 2 ways you can pay back the amount you borrow – gradually over time (referred to as Principal and Interest repayments) or in a lump sum (referred to as Interest Only repayments). Within the home loan lending environment, Interest Only products don’t tend to get repaid but rather, they revert to a Principal & Interest product after the Interest Only term expires. Interest Only terms are typically somewhere between 1 to 5 years while the remaining Principal & Interest term might be a further 25+ years on a 30-year term loan.

And if you take out a 30 year loan with a 5 year Interest Only option, your Principal repayments for the remaining 25 years and which kick in after the expiry of your 5 year interest only period will be proportionately higher than if you started off repaying your Principal at the commencement of your 30 year loan.

Plus, there are some lenders who offer a Variable Rate Line of Credit and there are some who allow you to prepay your interest a year in advance (which can be handy when you have a higher taxable income in a year which you can offset with the prepayment of interest when the interest is tax deductible).

All home loan products essentially take into account a mix of these 4 options. Each option combination has a different risk profile for the lender and is likely to have a different interest rate (or price) being charged to the borrower. There are no ‘set rules’ or even ‘rule of thumbs’ you can use to assess the perceived risk as risk profiles can change over time and lenders are continually updating their risk profiles. Below are some current risk profiles as identified in recent RBA data (as at October 2020).

There are a number of additional reasons the interest rate charged by a lender might vary in addition to the mix of products selected by the borrower – plus some of these factors might even result in particular lenders saying ‘no’ to providing finance:

– The borrower’s profile (including income, expenses, assets, liabilities, credit history, profession).

– The purpose for borrowing (typically either home (owner occupier (OO) Vs investment (IN); or established Vs off the plan Vs land & construction).

– The borrower’s identity (a natural person (like you and me!), company, trust, partnership or super fund).

– The amount being required to be borrowed (the total amount as well as the amount compared to the borrower’s income).

– The loan to value ratio (LVR) and whether the LVR is above the lender’s LVR limit resulting in the lender requiring the borrower to pay lenders mortgage insurance (LMI).

And finally, here are some other things to be aware of:

– Additional features provided by a lender may result in a higher interest rate as compensation for the lender for providing these features. For example, a loan without an interest offset account and redraw facility may have a cheaper interest rate. Additional features like an offset account can be very useful as they can reduce your total interest cost – and they may even be useful to have ‘in reserve’ in case you do need them – but as with all things, make sure you have thought this through otherwise you might be paying for something you never were likely to use.

– Interest rates vary between lenders as well as between a lender’s products. So, it is wise to do your homework and review the market. Nevertheless, not all lenders are going to be on ‘Page 1 of Google’. That is why it is prudent to consider using a great broker. Great brokers know far more lenders and lending options than could ever fit on Google’s page 1.

– No matter how attractive a lender’s interest rates appear in the marketing and advertising blurb, not all lenders’ products are available for all borrowers. As noted above, some lenders have quite tight restrictions on the criteria they use when considering whether to offer an applicant funding – and so you might not qualify for their ‘low rate’ product. Unwary borrowers can waste a lot of time preparing loan applications for loans they were never going to get or at a rate they were not going to be offered because they were not made aware of all the lender’s restrictions. Again, this is why applicants should consider using a great broker – because great brokers know more about each lender’s products than consumers and they know who and what to ask if there is a potential issue with a particular assessment criteria used by a particular lender.

– Beware ‘limited time’ offers with low interest rates – or honeymoon rates as they are often called. These rates expire and at the end of that time, your loan will revert to the lender’s then current interest rate.

– Fees and charges can vary for each loan. When considering fees and charges, Choice 1 suggests you need to take these into account under the heading ‘Watch the fees.’ Choice lists the following fees for consideration (I have regrouped them so it is easier to read:

– Upfront charges: LMI

– Ongoing fees: monthly or annual fees.

– Discharge fees & Break costs

I agree. However, be careful of not over-estimating the impact of fees and charges. For example, on a $500K loan, an interest rate differential of 0.1% pa equates to $500 pa. At present, most annual fees charged by lenders are less than $500 pa – so an interest differential saving of 0.1% pa when paying an annual fee of (say), $400 pa would mean you are ‘ahead’ by $100 pa. And even then, when we are looking at the overall cost of interest, this is not a great deal and in many cases, would not be considered material to your decision.

[1] Choice: https://www.choice.com.au/money/credit-cards-and-loans/home-loans/buying-guides/how-to-choose-the-right-home-loan

Before we start….

For further content, please visit https://www.bir.net.au/blog/

Now, back to the Article! 😉

Interest – what is it?

Interest rates reflect the price of money. The interest rate ‘price’ factors in a large number of variables including the lenders’ competitive environment and their need to be profitable.

Unlike most transactions with a supplier, your financial umbilical cord with a lender lasts a very long time – often up to 30 years. This element of time differentiates a lending product from most other consumer products. When you borrow money from a lender, there is an expectation by the lender that you will pay them back in full on the terms you have agreed and that you will also pay them ‘the price’ – or interest charges – for borrowing their money over the term of the loan.

Whilst it is arguable the ‘time risk’ reduces as years go by as property prices tend to increase and loan balances tend to decrease, there is an inherent risk, particularly in the early years of a loan. Lenders protect themselves from the potential risk of handing over large quantities of money by adding a margin on the interest rate they charge. Some won’t lend to particular types of borrowers because of the perceived risk.

What we know about interest

1. The longer the term of your loan, the more you will pay in interest. Interest rates matter, but so does the term of your loan. That is why when you consolidate your debts from higher interest credit cards into your lower interest home loan, it is important to pay off the debt you consolidated into your home loan as quickly as possible. If you pay it off over the full term of your home loan, you may well end up paying more in interest than if you paid it off over a much shorter period at higher interest rates.

For example, a credit card/personal loan debt of $100K incurring interest charges of 18% pa, will incur an interest expense of $18K over 12 months. The same debt, paid off over 25 years as part of your home loan at 3.0% pa, would cost $42K in interest . Even allowing for the ‘time cost of money’ (i.e. a dollar today is worth more than a dollar in the future), this is a large difference.

It is also why paying additional amounts or slightly higher amounts each month than you are contractually obligated to pay is recommended. You will reduce your principal more quickly and thus pay less total interest.

For example, a $750K loan paid off over 25 years on a P&I basis at 3.0% pa interest, will incur $317K in interest charges. If the loan term is 20 years, with the same interest rate, the interest charges will be $228K – $89K less.

2. Interest is the main expense charged by a lender. But it is not the only one. Whilst other costs such as monthly fees and charges, annual establishment fees etc might appear minor, they still have to be paid.

3. Interest rates change over time. Even fixed rates are only for a limited time (generally up to a maximum of five years). When you enter into a loan agreement with a lender, make sure you can afford the loan and allow for any increases in the interest rate. Our interest rates are at historical lows but less than 10 years ago rates for home loans were in the high single digits. And, for those old enough to remember ‘the recession we had to have’ in the early 1990s, you will recall rates of well over 15% pa with the highest rates an eye-watering 20%+!.