The Reserve Bank of Australia (RBA) began raising the cash rate for the first time in 12 years in May 2022, and the resulting interest rate rises have impacted many homeowners.
A fluctuating cash rate can create risks for people with home loans. In this article, we explain what these risks are and how you can avoid them.
3 risks that come with a fluctuating cash rate
1. Becoming trapped in a ‘mortgage prison’
If you’re a homeowner, you may have heard of the phrase ‘mortgage prison.’
You can find yourself in a mortgage prison if you have minimal equity and low borrowing power.
This can occur when house prices fall and home loan interest rates increase at the same time – a situation that is happening now in Australia.
If the value of your house drops, you may experience a drop in your home equity. And, if your home loan interest rate rises and your borrowing power decreases, you could find yourself in a ‘mortgage prison.’
If you’re in this position, you could find it difficult to refinance your home loan or you may not be able to refinance at all.
With interest rates increasing, many borrowers are looking to refinance to secure a more competitive deal on their home loan. However, this might not be possible if your equity and your borrowing power have decreased.
Even if you can refinance with less than 20% equity, you might have to pay Lenders Mortgage Insurance (LMI).
2. Falling into negative equity
Experiencing negative equity is a possibility when the cash rate is increasing. This is because a rising cash rate typically puts downward pressure on house prices.
Negative equity occurs when the value of your property falls below your outstanding home loan balance.
Let’s look at an example.
Let’s say you have a home worth $500,000 and an outstanding home loan balance of $440,000. If your property value falls to $430,000, you would be in negative equity.
Borrowers who have taken out large loans with low deposits in the last few years might be at higher risk of experiencing negative equity as home values decline and interest rates increase.
3. Being locked into a fixed rate when the cash rate drops
When interest rates were at historical lows in 2020 and 2021, many borrowers secured fixed rates on their home loans.
While this may be advantageous now as the cash rate rises, it might not be beneficial when the cash rate eventually falls.
Economists are predicting the cash rate will continue rising for the next few months, but there is a chance it could drop slightly in 2023 as the RBA reaches its target inflation rate.
If this is the case, borrowers on fixed rates could find themselves losing out on lower interest rates and decreased mortgage repayments.
Fixed rate borrowers coming off fixed terms now could also face the possibility of higher loan repayments if they roll onto a revert rate.
How to minimise the risks of a fluctuating cash rate
While you may not be able to remove the risks that come with fluctuating cash rates entirely, there are some steps you can take to mitigate them.
1. Build up your equity
Working on building your home equity can help to avoid finding yourself in a mortgage prison or experiencing negative equity.
While you may not be able to control housing values, you can work to pay off more of your home loan and own more of your home.
Here are some ways to build your equity:
Increase your monthly repayment amount: pay off more of your loan by even slightly upping your repayment amount, if you can afford it
Up your repayment frequency: repaying your loan fortnightly rather than monthly gives you 13 repayments per year rather than 12 – a simple way to pay off more of your loan
Make extra repayments: making one-off or regular extra repayments can decrease your home loan balance quicker
Undertake home improvements:
some home improvements, like a fresh coat of paint or some fixture refreshes, can add value to your home and up your equity.
2. Negotiate a lower interest rate with your lender
Landing a lower interest rate with your current lender can be a good option if you’re finding it hard to refinance your home loan.
You can do this by contacting your lender and asking them to lower your rate. It’s usually a good idea to know what other lenders are offering so you can compare rates.
It could also be worth checking if your lender offers new customers a lower interest rate than what they offer existing customers.
If you’re being charged a higher rate, you could be paying loyalty tax, which means you’re paying more on your home loan unnecessarily.
3. Refinance to a more competitive home loan
It’s important to note that refinancing might not be a possibility if you have negative equity.
However, if you are able to refinance, you could find a lower interest rate or better home loan deal with a different lender.
If you’re on a fixed rate home loan, you could incur break fees for refinancing your home loan before the end of your fixed term.
However, if the benefits outweigh the costs, refinancing could save you money.
Why is the cash rate rising?
The cash rate is rising in Australia to help bring down the inflation rate.
Inflation is the rate at which the price of goods and services increases. Inflation reached 6.1% in June – this high rate is being driven by supply chain issues and the war in Ukraine.
High inflation has seen the cost of living soar. The RBA is trying to bring inflation back to its target rate of 2-3% by increasing the cash rate.
Increasing the cash rate makes borrowing money more expensive. This discourages consumer spending, which in turn reduces demand for goods and services, and brings down inflation.
What are the predictions for the cash rate?
Since May 2022, the cash rate has risen by 2.25%.
It’s predicted that the cash rate will continue rising for the remainder of this year, and potentially into 2023.
The RBA has predicted the cash rate will peak at 2.5% as the target inflation rate is reached.
Do you have questions about how the cash rate is impacting your home loan? Your local Aussie Broker can answer them. Just book an appointment at a time that works for you.