It’s hard to imagine taking out a home loan with an interest rate of 17% per annum or higher, yet that was the reality for homebuyers in the late 1980s and early 1990s. And back then it would have been just as hard to imagine home loan interest rates of less than 3% p.a. The point is, ultra-low interest rates are not the norm, and while it might be tempting to load up on debt when interest rates are very low, it’s important to understand what can happen to loan affordability when interest rates rise. A (very) simple example Sarah and Evan have just taken out a $500,000 variable rate owner occupied home loan at an interest rate of 3% p.a. With a 25-year term the repayments are $2,371 per month. But what happens if, overnight, their interest rate jumps to 8% p.a.? Those repayments would suddenly become $3,859, an increase of $1,488 per month. Of course it’s extremely unlikely that interest rates would double or treble overnight, but even under a more realistic scenario th...
While we understand banks charge interest on their home loans, exactly what determines the rate? Should we be worried that interest rates will spike higher in the years ahead? For most people, it's all a bit of a puzzle. Traditionally, the Reserve Bank of Australia (RBA) is tasked with the responsibility of setting interest rates. It does this at monthly board meetings by determining the so-called cash rate, or the price the big retail banks pay to borrow money in the overnight cash markets. This is part of a complex mechanism the Reserve Bank uses to control the level of cash or liquidity in the banking system. Doing so directly impacts the rate of interest charged by banks, not just on home loans but also on every product they sell. This is a critical lever the Reserve Bank uses to regulate economic activity. For example, suppose the economy is slowing. In that case, the RBA can lower the cash rate, increase liquidity throughout the banking system and, in doing so, en...