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  • Writer's pictureBret Mullavey

Interest Rates: How They’re Set and Why They Vary So Much

If you've ever wondered why interest rates can seem all over the map, you're not alone. Understanding the factors that influence these rates can be a game-changer for anyone navigating the world of mortgages - both taking out a new one and looking for a better deal. Let's dive into the major elements that typically determine the interest rate you'll pay, focusing on the criteria you often see on a bank's website.



Understanding Risk

At the heart of it, banks and funders set interest rates based on risk. The higher the risk, the higher the rate. Simple, right? Well, it gets a bit more nuanced from here.



1. Loan-to-Value Ratio (LVR)

One of the key factors is the Loan-to-Value Ratio, or LVR. This is the ratio of your loan amount to the value of the property. For example, if you have a $1,000,000 property with an $800,000 loan, your LVR is 80%. Conversely, a $500,000 property with a $250,000 loan has a 50% LVR. A higher LVR indicates a higher risk for the lender, resulting in a higher interest rate.

Loan Amount

Property Value

Loan Ratio (LVR)

$800,000.00

$1,000,000.00

80.00%

$500,000.00

$750,000.00

66.67%

$350,000.00

$900,000.00

38.88%


2. Repayment Types: Principal and Interest vs. Interest-Only

The type of repayments you choose also plays a significant role. Principal and interest repayments mean you're steadily paying down the loan, which is seen as lower risk. Interest-only repayments, where the loan principal remains the same, are considered higher risk and often come with a higher rate. Regulatory impacts have made interest-only loans a bit pricier as well.


3. Owner-Occupied vs. Investment Property Interest Rates

Are you living in the property or renting it out as an investment? Historically, investment properties have attracted higher interest rates compared to owner-occupied ones. This wasn't so much about risk as it was about regulatory caps imposed by the Australian Prudential Regulation Authority (APRA) over the past decade. These caps have eased somewhat, but a slight premium on investment loans remains.



4. Packaged Loans vs. Unpackaged Loans

Loans can also be classified as packaged or unpackaged. Unpackaged, or standard loans, typically have an application fee but lower ongoing costs and a fixed interest rate. Packaged loans, on the other hand, often come with an annual fee and a different fixed rate. Which one is cheaper? It usually depends on the lender and the size of your loan.



5. Loan Size

Finally, the size of your loan matters. Larger loans often translate to more profitability for the bank, which can sometimes be rewarded with lower interest rates.



Window in Collingwood


Putting It All Together

Once you understand where you fit within these five criteria, you'll find it easier to determine what rate you can get and to compare rates from different lenders.

Understanding these factors can help you to make more informed decisions and potentially save thousands over the life of your loan.

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