How does the interest rate affect mortgage payments?

The interest rate charged on your mortgage is one of the most significant factors affecting the overall cost of the debt. When interest rates shift, so too will your mortgage payments, which can have a severe impact on your household budget. 

When interest rates increase, it may put a strain on your finances. On the other hand, if they are reduced, you’ll find some much-needed relief in your budget that month.  

Let’s explore how and why interest rates can affect your mortgage payments, and what you can do if you’re struggling to keep up.

Why do lenders change interest rates?

Over a 20-30 year loan term it is expected that interest rates will fluctuate on a home loan. This is because interest rates are influenced by the Reserve Bank of Australia (RBA)’s cash rate. 

The cash rate is the interest rate the RBA charges banks and lenders on their overnight loans. It is also subject to change because of fluctuating macroeconomic factors, such as inflation, wage growth, unemployment levels, gross domestic product (GDP) and more. 

If this sounds too much like economics 101, do not fret. All you need to know is that when the cash rate moves, lenders may change the interest rates on your home loan to follow suit, as well as on savings accounts and term deposits. 

Every first Tuesday of the month, except in January, the RBA meets to determine if the current economic conditions require the cash rate to rise, fall or stay on hold. This decision can affect millions of homeowners - particularly those on variable rate home loans - as a rising cash rate usually means higher mortgage repayments, and vice versa for a cash rate cut. 

A lender isn’t obligated to change the interest rate on its products every time the cash rate fluctuates. In fact, RateCity research found that the average of the big four banks’ lowest fixed rates increased between 0.35% - 1.31% in 2021 – despite no cash rate hike that year.

Still, it’s the expectation and typically what homeowners often anticipate to happen. Lenders can also choose to raise or lower the interest rate outside any cash rate changes based on their internal objectives. 

• If you are on a variable rate home loan, you can expect to experience these rate changes 20-30 days after you receive a notification letter about the rate adjustment.
• If you are on a fixed rate home loan, your interest rate and repayments will not change throughout the duration of your fixed term. However, after this period ends, you may find that the interest rate environment is higher or lower than when you first fixed your rate. 

What you can do if interest rates are too high

The interest rate charged on your mortgage affects the total amount you’ll repay over the life of your home loan. Any fluctuation in the interest rate changes the total amount your home loan will cost you. You should keep this in mind before you take out a home loan, especially if you’re thinking of choosing a variable rate home loan.  

It's a good idea to think about how you will manage repayments if the interest rate increases. In fact, as a rule of thumb it’s recommended that you test that you can afford a home loan with an interest rate at least 3 percentage points higher before you apply. 

If you already have a home loan and feel that your interest rate is too high, there are some options to consider to give your budget some relief:

Make extra repayments

If your lender allows for extra repayments without penalty, you may want to consider adjusting your budget and directing any extra funds into your mortgage. Making additional repayments can help to chip away at the principal owing, which may help to reduce your monthly repayments. 

Utilise your offset account

If your lender provides an offset account, you may want to consider putting some savings into this handy linked transaction account. Any funds you deposit into the offset account will, as the name suggests, help to ‘offset’ or reduce the amount of interest you pay on your mortgage.  

For example, if you have a $500,000 home loan balance and $50,000 in your offset account, the lender will charge you interest as if your loan balance was $450,000 instead. This could significantly reduce your mortgage repayments. 

Plus, you have the added bonus of being able to withdraw these funds if needed, such as for a holiday or a renovation.

Consider refinancing

If you’ve been a home loan customer for many years now and your interest rate and mortgage repayments are becoming too challenging to manage, it may be worth considering refinancing to a lower-rate lender. 

Refinancing involves switching your home loan from one lender to another, or to another home loan option with your current lender. This process can be costly, however in some cases the savings you may make could cover these costs after some time - also known as the break-even point. 

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