How do banks determine your Home Loan Interest Rates: What you Need to know

How do banks determine your Home Loan Interest Rates: What you Need to know

You’ve found the perfect home. As you sign the offer to purchase, you realise you need a home loan. Welcome to the season of paperwork, forms and mortgage originators spamming you for information! At this time, it is prudent for you to understand how to get a favourable interest rate on your mortgage. This little number can be critical for your finances – especially with an eye on interest rates going up in the near future!

So how do you get a better interest rate from the bank? We’ll dive into the world of home loan interest rates, uncovering the factors that determine your interest rate when you borrow for your dream home – and you can use this to get a better deal.

How the interest rate affects your pocket

Did you know that a 0.25% interest rate difference could make a R 42 000 difference over 20 years? Follow the calculation below:

Let’s say you buying a property for R 1 million.
At an interest rate of 11.75%, you’ll be paying back R 10 837.00 monthly, and R 2 600 897.00 in total over the whole term.
However, if you have an interest rate of 12%, R 11 011.00 per month will be payable – and R 2 642 607.00 over the 20-year term.

Wow! For this reason, it’s vital to get the lowest interest rate possible to save as much money as you can.

 The Bank’s Secret Formula for getting a home loan

Have you ever wondered what happens behind the scenes when banks decide your home loan’s interest rate? It’s not just about your credit score, but it does play a part. There’s a secret list that the bank implements as a benchmark for a prime interest rate. If you adhere to more than the benchmark, you get below prime. If you fall short – well, your interest rate will make my strong coffee go weak at the knees.

Having worked in the home loan industry for a few years, I know some of the factors that the bank uses in this secret list. Here are some of the factors that determine your interest rate – enjoy!

How to get a better interest rate

Level of education and how it affects your interest rate

I’m sure you never thought that your BA degree will come to your rescue. However, the bank loves well-educated people (even if it’s a BA degree), as it sees it as lower risk. Please include your full educational history // highest qualification in your application.

Does marriage affect your home loan? 

Just after I got married, and had to let my insurer know. Amazingly, they lowered my premium because statistically, married people drive safer. In the same way, married people get lower interest rates, because they see their relationship as more stable. Please don’t get married to the closest person or coffee cup – it’s a serious commitment.

Employment and income stability and your home loan interest rate

It is unfortunate that the South African landscape is very much against self-employed individuals. Lenders tend to give you money more easily if you have a steady job history and reliable income. Therefore, it might be prudent to stay at an employer for 2 years or more to get a better interest rate and rather not apply for a home loan within the first 6 months of starting at a new job – the bank sees you as risky during this time!

Job-hopping is frowned upon, and as a bonus, if you’re in a high-risk industry (such as the building industry), you might be required to take out extra retrenchment cover every month in case something happens.

Credit Scores do affect the interest rate of your loan

Of course, your credit score remains a significant player. The banks mostly use Experian for their credit checks, whereas one or two banks still use Compuserve. The bank tries to establish if you pay back monies owed. Therefore, you need to pay back debt within the timeframe agreed upon. If you have a judgment against you or are under debt review – then you’re going to have a hard time getting a home loan.

Therefore, monitor your credit score at least once a year to make sure you’ve not missed any weird payments with the cellphone number (or bank account details) that’s changed.

Negotiate Your Deposit – get a better interest rate

Never overlook the significance of effective negotiation, especially when it comes to your deposit. When applying for a loan, consider seeking a 100% loan initially and then leverage your deposit to negotiate for a lower interest rate based on the amount you’re willing to put down. A substantial deposit can tip the scales in your favour and secure you a better interest rate. It’s all about leveraging your financial strengths. Here’s an article on how to negotiate interest rates for your home loan.

Interest Rate Type: Variable vs. Fixed

Choosing between variable and fixed interest rates is vital. Typically, variable rates tend to be lower, offering more flexibility but could potentially rise in the future. Fixed rates, on the other hand, offer stability but is a LOT higher. Most people in the property industry agree that in the starting term to go with a variable interest rate, as you will be paying off more of your principal faster.

The Credit Stress Test

Imagine you had a credit card with R 1 million available to you. You are a R 0, which means you’ve not used it. Now if you decide to buy a property and then go and max out the credit card to buy used coffee grounds, it would significantly impact your finances and ability to repay money back to the bank. Therefore, simply possessing a credit card, even if unused, may influence your interest rate.

The banks know of these limits and will stress test your money situation – what would happen to the purchaser’s financial situation of the interest rates would go up with 1%? what about 3%?

Loan-to-Value (LTV) Ratio:

LTV is the ratio between how much you need for the home loan and what the property is worth. If you’re trying to buy a R 2 million property and get a home loan for R 3 million, the bank’s red light alarm system will go off and people will be evacuated – you won’t get a good interest rate. However, if you buy a property worth R 1 million for R 600 000, then the bank will give you more a favourable rate – as it can always resell the property at a profit if you default.

Debt-to-Income (DTI) Ratio and disposable income

The bank likes people who can work well with their money. And having good cash flow is part of this. If you have lowe debt and high income, the bank will see this as a lower risk. 

Loan Term:

The bank wants to make as much money from you as possible. Therefore, home loans with longer terms, such as 30 years, might get a lower interest rate – but you’ll be repaying a lot more money over the term. In the above example of a R 1 million home, if you have a 11.75% interest rate, you’ll be repaying R 3 633 875.00 over 30 years – compared to R 2 600 897.00 over 20 years.

Market Conditions:

We know that the reserve bank sets the prime interest rate. This is why interest is always quoted as prime plus or prime minus. We also know that during COVID, interest rates fell to their lowes in more than 50 years. People became instant millionaires, able to afford properties they would never have dreamed of – because prime plus 5% was a affordable 12%. Sadly, we’ve seen a steady rise in interest rates. As of February 2024, it’s sitting at a steady 11.75%.

It’s good to be aware of market conditions and plan for these scenarios.

Property Type, Location and interest rates

Your property’s type and location are pivotal in determining the best interest rate. Whether it’s a townhouse or a city apartment, each has unique traits observed by lenders. The location, whether urban or suburban, adds to its value. For instance a Property Type: 3-bedroom freehold townhouse in a secure complex with access to a pool and gym, location: Fourways, Sandton, Johannesburg could yield a better interest rate than a 1-bedroom flat in Hillbrow, where the block is falling apart and taken over by squatters.

The factors influencing interest rates and what you can supply to potentially secure a better rate:

To make your life easier, I’ve drawn up a table of things to include in your application. Most of these are already included, but you can still better some of them, such as a deposit or credit score.

FactorWhat to supply
Level of educationHighest level of education
Marital statusProof of marriage
Employment and income stabilityStable job history, reliable income
Credit scoreRegularly monitor and improve credit score
Negotiate your depositConsider a 100% loan, leverage deposit for negotiation
Property price
Loan-to-value Ratio
Get a Lightstone report before you sign the offer to purchase.
Don’t buy a property for more than it’s worth.
Interest rate TypeVariable is generally better
Credit stress testCheck beforehand what credit facilities you have
Property type and locationKnow your area and the sectional title scheme // HOA
Debt-to-Income // Cash flowHave some serious cash flow, as you can only repay
30% of your income on property.
Loan termYou can choose to favour interest rate of total amount repayable.
Market conditionsStay informed about the economic condition

Conclusion

Navigating the maze of factors influencing home loan interest rates can be overwhelming. However, armed with this insider knowledge, you’re better equipped to position yourself for the best possible rate.

The quest for the lowest home loan interest rate might seem like drinking tea – an impossible task. But armed with insight and strategy, you can navigate these waters and unlock substantial savings on your homeownership journey.

Remember, it’s not just about the lowest rate. Your interest rate is just one piece of the puzzle. The repayment term, total amount repayable and special clauses in your Final Grant from the bank that counts.

Happy Investing!

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