Rising house prices can help you pay off your mortgage a lot quicker. Yes, really.

If you’re an Australian with a mortgage, you’re probably paying too much interest, even if you got the best deal you could afford back when you first signed on the dotted line.

Today, you may be in a financial position where you’re eligible for a much more affordable home loan and not even know it, all because of Australia’s rising house prices.

Why you’re likely paying too much for your home loan

The biggest cost involved with almost any home loan is the interest rate. Lenders base the interest rates they charge on the level of risk involved when lending money to a borrower. To a bank, the less likely you are to pay back a loan, the higher the rate of interest they need to charge to cover their potential losses if you default on your repayments.

One figure many lenders use to gauge a borrower’s riskiness is the Loan to Value Ratio (LVR) – an expression of how much money is being borrowed compared to the total value of the property being purchased. Generally, the higher the LVR, the higher the level of risk, and the higher the interest rate the bank is likely to charge.

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You may be in a financial position where you’re eligible for an affordable home loan and not even know it. (Image: iStock)

For example:

Five years ago, Marcia bought a studio apartment for $300,000. At the time, she could only scrape together a deposit of $30,000, or 10% of the purchase price, meaning she needed to borrow $270,000. This gave Marcia an LVR of 90%.

Because Marcia’s bank considers any borrower with an LVR higher than 80% to be “high risk”, they charged Marcia an above-average interest rate compare to their standard home loans. Additionally, she had to pay Lender’s Mortgage Insurance fees to further cover her bank in case she defaults.

Why you may be in a better financial position than you realise

If you’ve glanced at the news at any point over the past few years, you’ll have likely noticed that house prices have been steadily rising in most Australian capital cities. Some areas have seen more growth than others, though a few have had their property values decrease (e.g. Perth).

If you previously bought property in a growing area, your home or investment will likely have increased in value (also known as capital gain or capital growth). Because you own the property, this capital growth increases the level of equity you have in your property – equity being your property’s value minus the amount still owing on your mortgage.

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For example:

Marcia’s mortgage repayments over the past five years have knocked $20,000 off her loan’s principal. Combined with her initial deposit of $30,000, she’s now invested $50,000 in the property.

Marcia’s flat is located in a popular area, and has grown in value from $300,000 to $500,000. When this capital growth of $200,000 is combined with the $50,000 that Marcia has already paid onto the loan, her total equity in the property is now $250,000.

How does this get you a better interest rate?

Remember how lenders base their interest rates on the riskiness of borrowers? And remember how they use LVR to measure this level of risk?

If your home has gone up in value in recent years, your increased equity would lower your LVR. This makes you a lower risk to banks and lenders, as the higher value of your property would better cover the cost of the loan if you were to default.

If you choose to refinance your home loan – that is, apply for a new home loan to replace your existing one, possibly switching to another lender in the process – your lower LVR is likely to qualify you for a significantly lower interest rate, which could make a big impact on your personal finances.

Alternatively, ambitious borrowers might seek to leverage their equity to borrow even more money, and use these funds to buy another investment property. This strategy can be risky, so seek independent financial advice first!

Refinancing your home loan could have a big impact on your personal finances. (Image: iStock)

For example:

Marcia still owes her bank $250,000 for her mortgage, but because of the capital gains over the past 5 years, her property is now worth $500,000, giving her an LVR of 50%.

If Marcia was to refinance her mortgage (either with her current bank or a different lender), this lower LVR would mark her as a safer risk, and make her eligible for a significantly lower interest rate. This would mean lower mortgage repayments for Marcia, putting more of her money in her pocket to be spent however she wants.

This article has been submitted by RateCity.