How do banks calculate your rate?

22nd August 2020 - Freya Cormack

How do banks calculate your rate

Have you ever wondered how your bank works out your interest rate? In this article, we’ll run through all you need to know about how banks set home loan interest rates. 

Your bank will calculate your interest rate based on a variety of factors. The most important factor they consider is the Reserve Bank of Australia’s cash rate. The cash rate dictates how much interest your bank has to pay on their overnight loans. Your interest rate will always be higher than the cash rate, but interest rates should adjust with the cash rate. 

The RBA cash rate

The cash rate is set on the first Tuesday of every month, except for January, at 2:30pm. It is essentially the interest rate that banks will charge each other when borrowing through overnight loans.

Your bank will use the cash rate to decide what interest rate to charge for home loans, and other loan or credit products. As mentioned above, your interest rate won’t match the cash rate exactly. After all, your bank makes money through interest and higher interest rates are charged to high risk lenders and loans. 

For example, personal loans are considered to be high risk. Unlike with a home loan, there won’t necessarily be an asset to seize if the borrower defaults on a personal loan. To account for risk, a higher interest rate will be charged. 

If a borrower has poor credit, low income relative to the property they plan to purchase, is purchasing in a ‘risky’ area or has limited documentation, they may be perceived as high risk. These borrowers may be charged a higher interest rate than the usual. 

All homeowners and prospective homeowners should keep an eye on the cash rate. When the cash rate drops, this is often a good time to refinance or apply for a loan as interest rates should also drop. 

Do banks pass on interest rate cuts?

This depends. Most banks will usually pass on rate cuts to customers to keep them from straying. 

Banks will eye their competitors to see whether they should increase or decrease interest rates. If their competitors aren’t passing on cuts, they don’t have much incentive to since there won’t be an obvious alternative for customers to turn to. 

However, the Big 4 major banks aren’t ruling the lending scene anymore. Their pool of competitors grows regularly, with new lenders emerging and smaller banks expanding their services. 

Increasingly, these smaller lenders offer more competitive interest rates. This means that the traditional banks can’t afford to withhold cuts to their customers. 

What to do if your bank doesn’t pass on rate cuts

If you’re on a variable rate home loan, it’s important to be aware of changes in the cash rate. When the cash rate drops and your bank doesn’t reduce your interest rate, try to contact them and demand a lower rate. A mortgage broker can assist with this step and may negotiate you a better deal.

But if your bank won’t budge, consider refinancing with another bank. There are plenty of other options out there. Compare rates online and don’t forget to consider the home loan beyond the interest rate. It’s no good being stuck on a home loan with a low interest rate if you have high fees and poor communication. 

For fixed interest rate borrowers, your interest rate will remain unaffected by cash rate changes. When you are nearing the end of your fixed period, it’s smart to monitor the cash rate so that you are prepared to make a switch. 

How is my interest calculated?

Your interest is calculated on top of your loan balance every single day. This means that you can’t really be strategic with making extra repayments or changes. While interest is calculated daily, you’ll pay it when you make your regular principal repayments — monthly, fortnightly or weekly. 

What your bank will do is multiply your remaining loan balance by your interest rate. This figure is then divided by 365 (even on a leap year) to get your daily interest amount. For example, if your loan balance adds up to $200,000 and you have a 4% interest rate, your daily interest will be charged using this formula:

($200,000 x 0.4) ÷ 365 = $27.39

If you have a redraw facility or an offset account, you could be charged less interest. 

Who pays more in interest?

Apart from the high risk borrowers we mentioned earlier, there are some other borrowers who can expect to be paying more in interest. 

Property investors

Investment home loans come with higher interest rates than owner occupied home loans. This is because investors can expect to have a rental income and a series of tax benefits. 

And don’t think you can play the system! If you are treating your property as an investment property while on an owner occupier home loan, you can get into serious trouble for fraud.  

Interest only mortgages

Interest only mortgages are a loan type where the borrower only pays back the interest on the loan, not the principal. Then, after the 1 to 5 year interest only period is over, they’ll be required to pay the principal amount too.

This loan structure is popular with savvy investors. They use this loan to buy a property in a high growth area, maximise their tax deductions and sell the property at a gain before the interest only period ends. 

However, interest only home loans are hard to get right and are considered risky. It’s difficult to even get approved for one and regardless, your interest rate will be higher than a standard owner occupier interest rate. 

Homeowners with a long repayment term

While most home loans come with long loan terms that well exceed 20 years, the longer you take to pay off your mortgage, the more interest you will have to pay. 

Where possible, try to make extra repayments to get your loan balance down so that you can stop paying more in interest than you need to. If your income increases, consider upping your repayment amount so that your loan term will decrease.

Don’t go beyond what you’re financially capable of doing, but it’s worth looking into ways to pay off your loan sooner. Another option to reduce your interest is to use an offset account. An offset account is a savings account linked with your loan balance. Any funds in here will offset how much interest you are charged. A redraw facility does a similar thing, only instead the funds in it are from extra loan repayments. 

Fixed interest rates

Most homeowners will know that fixed interest rates will almost always be higher than variable rates. Despite this, it doesn’t necessarily mean that you should switch to a variable rate home loan.

A variable interest rate is dependent on the cash rate, making it an often unstable choice. However, it comes with added flexibility and the option to add on loan features and make uncapped additional repayments. 

On the other hand, your fixed rate loan will be reliable and secure. If interest rates rise, you won’t be affected during your fixed period. Since you’ll know exactly how much to repay every month, you can better manage your budget. 

However you choose to repay your home loan, make sure it is inline with your needs and priorities. For professional advice, seek help from a mortgage broker.

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The information in this post is general in nature and should not be considered personal or financial advice. You should always seek professional advice or assistance before making any financial decisions.

Rate my Bank is powered by Lendi and Lendi is the trading name of Lendi Pty Ltd (ACN 611 161 856, Credit Representative 518849), a related body corporate of Auscred Services Pty Ltd (ACN 164 638 171, Australian Credit Licence 442372). We will never sell your email address to any third party or send you nasty spam, promise.

*WARNING: This comparison rate is true only for the example given and may not include all fees and charges. Different terms, fees or other loan amounts might result in a different comparison rate. The comparison rates are based on a loan amount of $150,000 over a loan term of 25 years. Fees and charges apply. All applications are subject to assessment and lender approval. Quoted rate applies only to PAYG loans with LVR of 80% or less with security in non-remote areas. All applications are subject to assessment and lender approval.

^The estimated average future interest savings is calculated as at 15 April 2020 based on Lendi assisting customers into new loans with an average interest rate reduction of 0.89% for the 11 months prior, and assuming a median loan term of 26 years on both the old and new loan and all monthly principal and interest repayments will be made on time. Any future savings figures are estimated averages only, and do not take into account any product features or fees (including refinancing or break costs). Your savings will be different.