Tuesday, 21 October 2014

What is a normal home loan interest rate?

When you look to buy a house, chances are the first question you will ask is "how much can I afford to pay" which is really asking the question "how much can I borrow?".  Once you know how much you can borrow, you can go out house hunting and buy that perfect home.

Unfortunately most people just Google one of those home loan calculators or go into a bank branch and ask them how much they can afford to pay and don't look at the biggest assumption that will determine the answer to the original question...the interest rate on the home loan.

The interest rate is the biggest unknown factor when it comes to taking out a loan

In Australia, most loans are variable rate.  If you are lucky you may be able to lock in a 5 year fixed interest period but for the majority of your loan you will be paying an unknown rate of interest.  Why is this a problem?

The problem is that most 'affordability' calculators assume the prevailing interest rates or they may have a small buffer in there if rates move.  In Australia the current rate of interest is ~5% on 30 year mortgages but will it stay like this forever...and will you be able to afford the interest bill if the interest rate moves?

The question we should be asking is: What is a 'normal' home loan interest rate?

The problem with this question is that there is no right answer.  Economists will argue until the cows come home what a steady state 'normal' interest rate will be but the fact is that it will all depend on the economic conditions and government policy in the future and there is too much uncertainty around that question.

So how do we deal with the uncertainty associated with unknown future interest rates?

The simple answer is to build in buffers.  Don't assume the current low interest rates will last forever.  I had always assumed a buffer of ~2% but you need to know that interest rates can and do go much higher.

I didn't quite realise how high interest rates could go until I was talking to my dad recently.  He took out a loan in the recession in Australia in the early 1990s and he said that the interest rate was 17% for the first few years of the loan.

Now I'm not suggesting that you build that large a buffer into your thinking (otherwise none of us would ever own property) but it is worth keeping in mind that interest rates can and do go very high.

It's not all doom and gloom!

The good news is that it is not all doom and gloom!  There are a few things working in your favour if you are taking out a loan in the current low interest rate environment:
  1. You can fix in a very low interest rate at the moment for several years
    • Banks will currently let you fix your rate on your loan for up to 5 years and you're still paying below 5%
    • You don't have to fix all of your loan either (fixed rate loans tend to be much more restrictive when it comes to paying back excess principal)
  2. If you have built a buffer into your thinking you will have excess cash to pay down your loan
    • I would never borrow up to your limit - always leave a buffer in there for interest rates to move and for things to go wrong
    • If you have a buffer the chances are that you have more cash than you actually need to pay down your loan and while interest rates are low you can really make a dent in the principal component of your loan
  3. Your wages should continue to increase over time...while your loan doesn't
    • When you look at your monthly (or fortnightly) repayments you may think that 30 years of that payment will really hurt but the fact is that your wage should increase over time
    • Even if you only get a 2.5% increase every year, in 4 years your wage is ~10% higher than it was today...while your repayments are still the same
    • This doesn't mean that you should borrow based on these future increases...it means just means that it is not all doom and gloom!

So what is the 'normal' interest rate?

Simply you don't and you can't know.  The only thing you can do is to prepare yourself for the uncertainty that comes with having a home loan.  Do this by building in buffers, pay more of your loan down than you need to in so that you have a buffer for the future and never ever stretch yourself to the limit.

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1 comment:

  1. Hey 90Million,

    Yes I agree with that, it is likely that interest rates will fluctuate however fixing a part of it and gaining the required buffer in place should be able to mitigate most of that risk :)..

    Hopefully we're unlikely to get to the 19% interest rates again and if we do, imagine the amount of cash we'd be able to earn anyway, then again I wonder what the interest rate offered on deposits were back then..

    How'd South America go? Maybe you're still there and this is on auto-post :)