Information about Home Loans
Need help with a home loan?
Finding your own home loan can be just as crazy as trying to self diagnose a medical problem. You may get it right but the chances are that you could be way off the mark which could end up costing you tens of thousands of dollars.
This page sets out general information on aspects of home loans – we compare Interest Only vs Principal and Interest, Line of Credit vs Term Loans and Variable Rates vs Fixed Rates. We also explain terms such as Mortgage Insurance, Loan to Value Ratio (or LVR), Conditional Approval, Offset Account and Redraw but if you are a First Home Buyer, Property Investor or someone that is having problems with finance, then you will also find more specific information elsewhere.
Interest Only vs Principal & Interest
This covers how much of your loan you are repaying each time that you make a repayment.
If all that you are doing is meeting the interest that is due each month, then your repayments are Interest Only. The repayments on this basis are lower than they would be if they were Principal & Interest repayments but the downside is that you are never reducing the amount that you owe as the principal remains unchanged. On the other hand, with Principal & Interest repayments not only are you repaying the interest for the month but a small portion of the amount that you borrowed as well.
Interest Only repayments are usually most applicable for investment loans. Principal & Interest repayments are usually most appropriate for home loans for an owner occupied property.
An interest only period can be up to ten years at which time it reverts to Principal & Interest.
Generally, Principal & Interest repayments are the same each month whereas Interest Only repayments usually vary each month depending on the number of days in the preceding month.
Line of Credit vs Term Loan
A Term Loan is what most people refer to as a home loan. You borrow money from a lender and agree to repay that loan over a certain number of years. It may be that the loan repayments start out as Interest Only repayments but at some point they will convert to Principal & Interest repayments so that the loan is repaid over the agreed number of years.
There are different types of Lines of Credit but a true Line of Credit is where a lender agrees to provide you with access to a certain amount of money (called the Credit Limit) that you can use as required. Most lenders will require you to pay in at least the amount that you need to cover the interest due each month but there is no requirement to repay the loan during the term of the loan.
Many people believe that a Line of Credit is a great way of repaying a loan quickly but this is usually not the case as the interest rate under a Line of Credit is usually higher than with a Term Loan and the same result can often be achieved with a Term Loan with 100% Offset account attached.
You need to be very disciplined with money if you want to use a Line of Credit as a way to repay your loan faster.
Variable Rates vs Fixed Rates
Having a Fixed Rate means that you will know exactly what your interest rate will be for the nominated Fixed Rate period – which is usually for 2 – 5 years but can be as long as 15 years with some lenders! During this time, the interest rate being applied to the loan will not alter regardless of any changes in the variables rates offered by that lender.
People tend to go to Fixed Rates because they like to be in control of their finances and know exactly what their commitments will be over a period of time. This allows for better budgeting but can come at a price if rates do not move in the direction that you expected.
Another downfall that a lot of people are not aware of is the fact that if you start paying above your scheduled repayments, you could end up being hit with break costs by your lenders. Most lenders allow a certain amount of additional payments but it does vary from lender to lender.
With variable rates, the interest that you have to pay will vary from time to time in line with movements in the variable rate offered by the lender. Traditionally, rates only varied in line with changes in the Official Cash Rate set by the Reserve Bank but over the last couple of years, lenders have changed variable rates independently of the Reserve Bank.
Loan to Value Ratio
In simple terms, the Loan to Value Ratio (which is also referred to as the LVR) is the percentage that is worked out by dividing the total home loan debt by the value of the property being mortgaged. As an example, if the total home loan debt is $400,000 and the value of the property is $500,000, then the LVR is 80%.
The LVR is significant in a number of ways. Firstly, lenders have a maximum LVR that they will lend to depending on the property being offered or the type of borrower.
The LVR also affects the amount of Mortgage Insurance that needs to be paid. This is generally required where the LVR is above 80%.
This can be a huge cost when taking out a loan although it does depend on the Loan to Value Ratio (LVR).
For clients who can prove their income, it is usual for Mortgage Insurance to be payable if they are borrowing more than 80% of the value of the property but for self employed borrowers who don’t have up to date financial statements or tax returns, it can apply from a lower LVR.
The less the deposit that you have, the higher the cost of the Mortgage Insurance.
Mortgage Insurance only provides protection for the lender in case the borrower defaults. Contrary to what many borrowers assume, it does not provide any insurance at all for the borrower even though the cost of it is worn by the borrower.
A Conditional Approval (sometimes also called an Indicative Approval) is usually the first response that you get from a lender once a loan application has been lodged but it can range from being an Approval that means very little to one that is a very good sign that a loan will most likely be approved.
A Conditional Approval issued before the lender has assessed a complete loan application and all supporting documentation – which can take up to 3 – 4 working days – is usually little more than an inducement to lodge an application.
However, a Conditional Approval that has been issued after a loan has been assessed will clearly set out the conditions of the approval with the most common one being that the approval is subject to a satisfactory valuation of the property that is involved.
A redraw facility on a home loan lets the borrower make extra repayments that can be redrawn at a later date. Different lenders have different policies on redraws and it is important to understand factors such as minimum and maximum amounts that can be redrawn as well as any fees involved and how the redraw can be arranged.
Making extra payments by utilizing funds that are not otherwise required on a day to day basis can significantly reduce the payments or the term of the loan.
These are fees that lenders charge for the economic loss that they suffer when you break a fixed rate. Break costs are charged if you sell a property, refinance a loan or pay much than allowed off your loan whilst it is on a fixed rate and the interest rates have fallen since the rates were fixed.
The reasoning behind this is that the lenders have purchased the funds for your loan for a fixed period of time and they need to honour their commitment. This would leave them out of pocket.
Lenders have their own method of calculating break costs and they cannot project what your break costs would be in the future as the rate that is applicable is the rate on the day that the break costs are applied.
Fixed Rate break costs can be quite horrendous and can be up to $30,000 so if there is ever a chance that you may sell the property or otherwise repay the loan during the fixed rate period, then you need to seriously consider whether fixed rates are right for you.
You would not generally be charged break costs if the interest rates have risen since you fixed your rate.
One of the best ways to save money on a home loan is to make use of an offset account.
In simple terms, an offset account is a bank account that is attached to a home loan.
However, instead of earning interest on your funds which may then be subject to tax, the funds are taken into account when calculating the interest that is due on the home loan.
For example, if you have a $240,000 mortgage and have funds in your offset account of $12,000, then interest will only be calculated on the balance of $228,000.
The big advantages of an Offset Account are that the interest that is applied to a 100% offset account is generally higher than you would normally get in any form of savings account and also that the money in the offset account will either reduce the amount of interest being charged each month (in the case of an Interest Only loan) or will reduce the term of the loan (where the loan is operating on a Principal and Interest basis).
There are some disadvantages however with an offset account in that you may pay a slightly higher interest rate or a monthly fee to have the offset account. Some lenders will also require you to keep a minimum balance in the offset account to gain a benefit.
An Offset Account is ideal for someone who keeps a large amount of savings over any period of time.
It is easier to keep track of funds in an offset account than funds that have been paid off the home loan as extra repayments and which can then be redrawn from time to time.
This when a lender uses your property (whether owner occupied or an investment) as security for other property that you purchase. It is generally considered to be something that a borrower should avoid at all costs.
Cross collateralisation can be an issue when you try to release a property – usually by selling or refinancing. This will cause the lender to revalue any remaining properties before allowing the property to be released.
If the value of any remaining properties have fallen, the lender will require that these loans are reduced to their previous LVR.
This can be a big issue if you have plans for the funds that you planned on getting from the sale or refinance.
Equity is the difference between what your property is worth and the amount that you owe by way of a mortgage. For instance, if the property is worth $500,000 and your loan debt is $425,000, then your equity is $75,000. Equity can be used as genuine savings as outlined below.
This is a term that refers to the funds that a lender will require you to have saved. Every lender has a slight variation on what they deem to be genuine savings and how long you must hold the funds for but as a general guide, the following definition gives a good guide:
- Savings, either in a transaction, savings or term deposit account for at least 3 months;
- Gifts are accepted provided they have been in the applicant’s account for greater than 3 months;
- Shares – providing they have been held in the applicants name for a minimum of 3 months;
- Equity in an existing property or sale proceeds.