Why Your Deposit Size Can Influence the Interest Rate You’re Offered
When applying for a home loan, the size of your deposit is one of the most critical factors that lenders consider. It not only determines your borrowing capacity but also plays a significant role in the interest rate you’re offered. In Australia, where property prices vary widely across regions, understanding the connection between your deposit size and interest rates can help you secure a more favourable loan and save thousands over the life of your mortgage.
This article explores the relationship between deposit size and interest rates, delves into the concept of loan-to-value ratio (LVR), and provides practical tips for maximising your borrowing power.
The Importance of Deposit Size in Home Loans
Your deposit is the amount of money you pay upfront when purchasing a property. Most lenders in Australia require a deposit of at least 5% to 20% of the property’s purchase price. However, the larger your deposit, the greater your financial advantage when negotiating loan terms.
Key Benefits of a Larger Deposit
- Lower Loan Amount: A larger deposit reduces the amount you need to borrow, which directly impacts your monthly repayments and total interest paid.
- Improved Loan-to-Value Ratio (LVR): A smaller LVR (discussed below) signals lower risk to lenders, often resulting in better interest rates.
- Avoiding Lender’s Mortgage Insurance (LMI): Deposits of 20% or more typically exempt you from paying LMI, saving thousands of dollars upfront.
What Is Loan-to-Value Ratio (LVR) and How Does It Relate to Your Deposit?
The loan-to-value ratio (LVR) is a key metric that lenders use to assess risk. It represents the percentage of the property’s value that you’re borrowing. The formula for calculating LVR is:
LVR = (Loan Amount/Property Value) x 100
Example: Calculating LVR
- Property value: AUD 600,000
- Deposit: AUD 120,000
- Loan amount: AUD 480,000
An LVR of 80% or lower is generally considered low risk, whereas an LVR above 80% is seen as higher risk.
Impact on Interest Rates
- Low LVR (80% or less): Borrowers with a low LVR are perceived as less likely to default, making them eligible for more competitive interest rates.
- High LVR (Above 80%): Lenders charge higher interest rates to offset the increased risk associated with high LVR loans. Additionally, borrowers may need to pay LMI, further increasing costs.
Why Lenders Offer Lower Rates for Larger Deposits
Lenders are primarily concerned with risk management. A borrower with a larger deposit poses less risk for several reasons:
1. Greater Financial Security
A larger deposit demonstrates financial discipline and a strong ability to save. This reassures lenders that you’re capable of managing repayments and other financial obligations.
2. Lower Risk of Loss for Lenders
If the borrower defaults, a larger deposit means the lender is exposed to less financial loss when selling the property to recover their funds. For example:
- With a 90% LVR loan, the lender has only a 10% equity buffer if property prices decline.
- With a 70% LVR loan, the lender has a 30% equity buffer, significantly reducing their risk.
3. Reduced Exposure to Market Fluctuations
A larger deposit insulates lenders from market volatility. In a downturn, properties with high LVRs are more likely to fall into negative equity (where the loan exceeds the property’s value), increasing risk for both borrower and lender.
Deposit Size and Lender’s Mortgage Insurance (LMI)
Lender’s Mortgage Insurance (LMI) is an additional cost applied to loans with an LVR above 80%. While LMI protects the lender, not the borrower, it can significantly increase upfront costs.
LMI Cost Example
- Property value: AUD 600,000
- Deposit: AUD 60,000 (10%)
- Loan amount: AUD 540,000
- LVR: 90%
With a 90% LVR, the borrower would need to pay LMI, which could range between AUD 10,000 and AUD 20,000 depending on the lender and the loan amount. Borrowers with a 20% deposit (LVR of 80% or less) would avoid this cost altogether.
Impact of Deposit Size on Total Interest Costs
A larger deposit not only influences your interest rate but also reduces the total amount of interest you pay over the life of your loan. Let’s compare two scenarios:
Scenario 1: 10% Deposit
- Property value: AUD 600,000
- Deposit: AUD 60,000
- Loan amount: AUD 540,000
- Interest rate: 5%
- Loan term: 25 years
Total Interest Paid: AUD 406,579
Scenario 2: 20% Deposit
- Property value: AUD 600,000
- Deposit: AUD 120,000
- Loan amount: AUD 480,000
- Interest rate: 4.8% (discounted rate for lower LVR)
- Loan term: 25 years
Total Interest Paid: AUD 352,749
Savings: AUD 53,830
Other Factors Influenced by Deposit Size
1. Borrowing Capacity
A larger deposit reduces your borrowing requirements, improving your affordability assessment. Lenders are more likely to approve loans with favourable terms for borrowers who demonstrate lower borrowing needs.
2. Loan Features
Borrowers with larger deposits may qualify for premium loan features, such as:
- Offset accounts to reduce interest costs.
- Lower or waived annual fees.
- Access to rate discounts for low-risk borrowers.
3. Flexibility in Negotiations
A strong deposit position gives you leverage to negotiate better interest rates or fees with lenders. Many banks offer rate discounts for customers with low LVRs.
How to Save for a Larger Deposit
Saving for a larger deposit can take time, but the benefits in terms of lower rates and overall costs make it worthwhile. Here are some tips:
1. Set a Clear Goal
Determine the amount you need for your deposit based on the property price and your target LVR. Aim for at least 20% to avoid LMI and secure better rates.
2. Create a Savings Plan
Establish a dedicated savings account and automate regular contributions. Track your progress and adjust your budget to prioritise savings.
3. Take Advantage of Government Schemes
In Australia, first-home buyers may be eligible for assistance programs, such as:
- First Home Owner Grant (FHOG): A one-off payment for eligible buyers purchasing a new home.
- First Home Guarantee (FHG): Allows eligible buyers to purchase with as little as 5% deposit without paying LMI.
- Stamp Duty Concessions: Reduced or waived stamp duty in some states.
4. Reduce Unnecessary Expenses
Minimise discretionary spending, such as dining out or subscriptions, to boost your savings rate.
5. Invest Wisely
Consider placing your deposit savings in a high-interest savings account or a low-risk investment to maximise returns over time.
Alternatives for Borrowers with Small Deposits
If saving for a large deposit isn’t feasible in the short term, there are alternatives to help you enter the property market sooner:
1. First Home Loan Deposit Scheme
Eligible first-home buyers can purchase a property with as little as a 5% deposit, with the government acting as a guarantor to avoid LMI.
2. Guarantor Loans
A guarantor loan allows a family member to use the equity in their property to secure your loan, reducing your LVR and avoiding LMI.
3. Shared Equity Schemes
Some state governments offer shared equity schemes where they co-own part of the property, reducing your borrowing needs.
The size of your deposit plays a crucial role in shaping the interest rate you’re offered, your borrowing capacity, and the overall cost of your home loan. A larger deposit lowers your LVR, reducing lender risk and opening the door to better interest rates, premium loan features, and significant savings over the life of your mortgage.
While saving for a larger deposit requires discipline and planning, the long-term financial benefits make it a worthwhile investment. For those unable to save a substantial deposit, exploring government schemes, guarantor options, or alternative strategies can help you achieve your homeownership goals while managing costs effectively. Whatever your situation, understanding the impact of deposit size empowers you to make informed decisions and secure the best possible loan for your needs.
Learn how your deposit size impacts home loan rates, borrowing capacity, and overall mortgage costs in Australia.
