How do banks work?

How do banks make money?

Banks make a majority of their profit from attracting deposits (i.e. transaction and savings accounts) and lending that money to borrowers (i.e. for home loans, credit cards, business loans etc.) for more.  For example they may pay someone who deposits their money into a transaction or savings account a return of 0 to 2% and charge a borrower 4% plus (and up to 20% if that product is credit card) for that same money. So by charging a higher rate to borrowers than what they pay to their depositors is where they make their money.

What is a comparison rate?

A comparison rate is the interest rate taking into consideration the costs associated with the product that you have chosen to give you an idea as to the real rate that you were being charged. For example with a home loan you are charged an interest expense, however what customers often don’t realise is that there may be an application cost or an annual cost as well. The comparison rate adds on these additional costs to the interest rate and  so you have a better understanding of everything you are being charged.

Should my home loan be fixed or variable?

Home loans can be either on a variable rate where the rate varies usually based on the RBA official cash rate or on a fixed rate where the rate is locked in for a period of time (usually between 1 and 3 years). 

Variable rate loans have a number of pros and cons. Pros are that if the rate is going down, as soon as the RBA reduces rates these are normally immediately reflected in a lower variable rate. However if rates were to increase then your rate will rise appropriately. Other cons include the uncertainty of the market/ economy and as a result what rate you’ll be paying in the future. Another pro is that you can have an offset / redraw facility  attached that reduces the amount of interest you are charged  and gives you the ability to redraw excess funds out if required at a later date.

Fixed rates on the other hand provide customers with certainty of repayment over a period of time. This can be great if the rate you’ve locked into is low compared to a variable rate, however if the rates were to fall further then you’ll be paying more that those on a variable home loan. The other con is that if you happen to come into money (ie inheritance, sell your home etc) then you will need to pay a penalty rate for paying your loan out prior to your fixed term end date. This penalty normally reflects interest costs foregone by the bank. Also there have been studies that show that customers are normally better off financially by being on a variable rate by consistently being charged a lower rate. Fixed rate loans don’t offer redraw and offset facilities, which are a great tool for redrawing excess funds at a later point.

Either way banks are similar to a casino in that the house always wins. What I mean by this is that the bank always stacks the odds in it’s favour through having experts who set the rates and enforcing conditions that favour itself.

So if you’re after certainty then lock into a fixed rate, if you think that you want greater flexibility then a variable loan may suit, or you may want to lock in a portion and keep the rest on variable.

How do banks determine what interest rate you will be charged?

The interest rate you are charged is determined by the risks associated. So the higher the likelihood that you will default (i.e. not pay back the money borrowed), the higher risk to the bank and therefore the higher the rate they will charge you.

In essence the risk assessment is a number which reflects the riskiness of the client/ deal (usually between 1 and 10 – 1 being the best and 10 the worst and a letter that reflects security (i.e. what you are offering to secure the loan/ i.e. collateral) This is usually A to F, A being fully secured (that is if you were to go bankrupt, that the bank would be guaranteed to get their funds repaid in full (e.g. may include your home or property, a term deposit) and F being that no security is being offered/ or potentially something like a guarantee from yourself/ parents etc., however banks are unlikely to use this as it’s poor publicity (e.g. selling your parent’s home) for them and so becoming less used.

o   The level of risk is determined by factors such as your credit record . So things such as your age, the industry that you work, your credit record, your age, your track record, the assets and liabilities that you have, your spending patterns, your experience etc. A good track record gives them comfort that you are capable of repaying back the loan.

o   In relation to security the more you are will to put in and the level of security (i.e. the more comfortable the banks are to lending you money. Someone that is rated A would typically have funds invested in a term deposit / or something similar that matched the amount being lent. You may ask why borrow if you have the funds,  the typical answer is that with the help of a good accountant business costs and personal costs are treated differently and there may be some tax advantages to borrow in a business name.

So once the banks assesses your risk and security rating that will determine what they charge you for the funds lent. The lower the number and the letter the cheaper the interest charges will be on your loan. It is important to note that the bank will perform an annual review of your loans and this risk and security assessment will updated and this will determine the costs of borrowing for the next year. Therefore if you have paid everything on time and as expected then the interest you are charged may go down. Likewise if  you are constantly late, have an overdraft that is constantly at or near your line of credit limit then that will make the bank nervous and interest costs may go up.

Interest is the cost of capital and is determined by a number of factors including the overnight borrowing rate, the RBA cash rate, the cost of overseas funds, the rate they need to attract depositors etc. This in turn determines a base rate that a premium is added; the premium added is determined by the risk and security rating. So for example if the base rate is 5% (business rate is normally higher than the personal rate as there are larger amounts involved and a riskier proposition for the bank) then depending on your risk rating an additional amount will be added on top of this rate of 5%,  so the better your rating then the lower that amount is.