What you should know about home loans
A home loan or mortgage is a credit contract that allows you to purchase a property without having all the cash up front. Taking out a home loan requires significant investment and commitment as it is one of the biggest financial decisions you will make.
Home loans are complex, so you should take your time in finding the right loan for you. There are many decisions you need to make before you even apply for a loan, such as:
- the amount you can afford to borrow;
- the type of interest charged;
- the repayment type and frequency;
- whether you need additional features such as a mortgage offset account or redraw; and
- whether you want to package your home loan with other financial products offered by the lender.
Variable rate home loan
The repayments on a variable rate loan are subject to change as the interest rate on your loan changes.
The variable rate on your loan is determined by your lender and may take into account factors such as changes to the official cash rate, which is set by the Reserve Bank of Australia.
The main benefit of a variable rate loan is flexibility. Many variable rate loans allow you to make extra repayments, come with mortgage offset accounts, allow you to take repayment holidays, or have redraw facilities available.
Fixed rate home loan
The repayments on a fixed rate loan are fixed for an initial period of time and will not change during that period. Once the fixed rate period has ended, the loan will revert to the standard variable rate and the flexible features associated with a variable rate loan will become available for you to use.
The main benefit of a fixed rate loan is knowing exactly what your repayments will be.
Variable or fixed rate?
The choice between a variable or fixed rate will depend on your individual circumstances.
With a fixed rate loan, you know exactly how much your repayments are, allowing you to take that into account when budgeting. This can be helpful if you do not have a steady and reliable flow of income. Also, if interest rates increase, your repayments will remain the same.
Customers with fixed rate loans will miss out on any potential savings if interest rates decrease. Also, if you repay your home loan or choose to switch to a variable rate during the fixed rate period, your lender may charge you a fee.
Variable rate loans may come with a variety of flexible features to help you pay off your loan faster or access additional funds you have contributed in repayments. Also, if interest rates decrease, your repayments will also decrease.
Conversely, if interest rates increase, your repayments on a variable rate loan will also increase. When deciding how much you can borrow from a lender, you may consider using an interest rate buffer to determine affordability if interest rates increase. If interest rates move frequently, it can be harder to budget your finances as your repayments may keep changing.
Split home loan
Splitting your loan allows you to pay a fixed interest rate on part of your loan while paying a variable rate on the remaining part.
When you split your loan, you get the best of both worlds. You have certainty in knowing what the fixed portion of your repayment will be whilst still having flexibility in the variable portion of your loan.
Many lenders will allow you to split your loan multiple times which gives you the ability to decide how many fixed rate loans and how many variable rate loans you want.
A comparison rate is an all-inclusive interest rate i.e. it is a rate that includes the interest rate on the loan and any known fees charged by your lender relating to the loan.
The comparison rate does not include government charges such as stamp duty and mortgage registration fees or fees that are only charged when a specific event occurs such as early termination fees and redraw fees.
It is calculated on the basis of a secured home loan of $150,000 over a 25 year period.
The comparison rate is an indication of the true cost of the loan and can be helpful when comparing different loans from various lenders.
Try not to focus only on the interest rate and comparison rate when researching home loans. You should also consider features that may be important to you such as having an offset account or the ability to make extra repayments.
LVR refers to the loan to value ratio of your loan. The LVR measures the value of your loan relative to the value of the property and is an indication of the riskiness of your loan. The higher your LVR, the riskier lenders will consider your loan.
For example, if the value of the property is $500,000 and you have a $150,000 deposit (30%), your loan amount would be $350,000 and your LVR is 70%.
The value of the property may be taken as the purchase price of the property or the value of the property as determined by the lender.
Most lenders require that you pay Lenders Mortgage Insurance (LMI) when your LVR is greater than 80% to protect the lender in the case that you default on the loan. LMI is calculated based on your LVR. The higher your LVR, the higher your risk, and the higher the cost of your LMI. If you are switching loans and have a high LVR bear in mind that your previously paid LMI is not transferrable and you may have to pay LMI again.
Your lender may allow you to either pay LMI as a lump sum when you establish your loan or it can be added to your loan to be paid off by your regular repayments.
Principal and interest repayments
With principal and interest repayments, a portion of your repayment will comprise of the interest charged on your loan and the remaining portion will go towards repaying the principal amount borrowed. The idea is that, if you meet your repayment obligations, you will fully repay your loan at the end of the loan term.
Interest only repayments
Interest only repayments generally occur for a specific period of time. During the interest only period, your repayments only cover the interest charged on your loan i.e. you do not repay any of the principal borrowed. At the end of the interest only period, your repayments revert to principal and interest for the remaining term of your loan.
If your repayments are interest only for the entire term of the loan, you will need to repay the principal amount borrowed in full at the end of the loan term.
The main drawback of making interest only repayments is that by the end of the loan term, you will have paid more in interest than the case where you make principal and interest repayments for the entire term of the loan. This is because you do not repay any of the principal borrowed during the interest only period so interest is always charged on the full principal amount.
Home loan features
Mortgage offset account
A mortgage offset account is a bank account linked to your loan.
If the account has 100% offset, the entire balance of that account is deducted from your loan balance before interest is calculated.
If the account has a partial offset, a portion of your loan equal to the balance of the offset account is charged a reduced interest rate.
The larger the balance in your offset account, the lower your loan balance, and the greater the interest savings. A mortgage offset account effectively uses your own savings to reduce the total interest paid on the loan and can help shorten the time taken to repay the loan.
Mortgage offset accounts are generally more flexible than redraw facilities as many provide ATM access, giving you quick and easy access to your money without additional charges.
Many variable rate loans will allow you to make extra repayments in addition to your scheduled repayment. You may be able to make these regularly or as a lump sum on an ad hoc basis.
Most fixed rate loans do not allow you to make extra repayments during the fixed rate period or only allow you to do so up to a certain threshold. Make sure you check the terms and conditions of your loan contract before making extra repayments.
Making extra repayments will help you save on interest and allow you to pay off your loan earlier. Also, if you have a redraw facility attached to your loan, you may be able to draw on these additional funds and use them for other purposes.
A redraw facility allows you to access the funds you have paid in extra repayments.
Redraw facilities generally offer less flexibility than mortgage offset accounts. Your lender will often charge a fee when you redraw funds and may have minimum and maximum limits on the amount you can redraw and the number of redraws you can make each year.
Redraw facilities are more suitable for holding funds that you do not plan on using in the immediate future. When you redraw your funds, your effective loan balance increases, thus increasing subsequent interest charges.
A repayment holiday is a temporary period of time where you can take a break from making repayments. You may be able to stop your repayments or make an agreed reduced repayment.
A repayment holiday can be helpful if you require a short term break and need to free up your cash flow e.g. you are taking an extended holiday, your partner is taking maternity leave, or you are taking a period of leave from the workforce.
To be eligible to take a repayment holiday, lenders usually require you to have made extra repayments on your loan. Your extra repayments are used to cover your scheduled repayments during the holiday period.
If you have not made any extra repayments, your lender may allow you to add the interest charges you incur during the holiday period to your loan balance. At the end of your holiday period, your repayments will increase to ensure you repay your loan by the end of the term.
Repayment holidays can end up adding thousands of dollars to your loan balance so always discuss your financial situation with your lender before applying for a repayment holiday. Your lender may have alternative solutions such as reducing your interest rate or temporarily switching you to interest only repayments.
Establishment fees, also known as application, upfront, start-up, or setup fees, are a one-off fee charged at the beginning of your loan. It covers the cost to the lender to arrange and administer the loan.
Ongoing fees, also known as service or administration fees, are charged on a regular basis (e.g. monthly or yearly) throughout the term of your loan. It covers the cost of maintaining your loan.
Discharge fees are charged by your lender at the end of your loan term once you have fully repaid your loan. It covers the legal and administrative cost of discharging your loan.
Early exit fees
Early exit fees, also known as early termination or deferred establishment fees, may be charged by your lender if you repay your loan in full within a specified period of time (e.g. in the first 5 years of your loan term).
Lenders charge early exit fees to cover the loss incurred as a result of you terminating your loan early. These fees can be quite high and reduce the benefits of repaying your loan early or switching to a cheaper lender.
As part of the Australian Government’s banking reforms, early exit fees are banned from all new home loans signed from July 2011. The reform is designed to increase competition among lenders as it is less costly for customers to switch to a better deal.
Home loan package
A home loan package bundles your home loan with other financial products offered by your lender. Depending on your lender, your package may include multiple home loans, a transaction account, savings account, term deposit, credit card, personal loan, car loan, insurance, financial planning, margin lending, or stock broking.
Your lender will often offer you discounts or bonuses on the products in your package such as monthly account service fee waivers, interest rate discounts on loans and insurances, or interest rate bonuses on deposit products.
Most packages have a minimum borrowing requirement. This means that the lender requires your total borrowing across all your loans to be a certain amount to qualify for the package e.g. your total borrowing across all your loans must be greater than $250,000. Generally, the greater your borrowing total, the greater the interest rate discount on your home loan you will receive from your lender.
To be able to offer you these benefits, your lender will require you pay an annual fee that covers all the products in your package.
Home loan key facts sheet
A home loan key facts sheet summarises key facts about a home loan in a standard format. It was introduced as part of the Australian Government’s banking reforms campaign and from January 2012, lenders must issue you a home loan key facts sheet when you request it and must be available online via their website.
A home loan key facts sheet is a comparison tool that details the total amount you will pay back over the life of the loan, monthly and yearly repayments, and fees and charges based on the loan amount and loan term determined by the customer.
The home loan key facts sheet makes it easier to compare different loans from various lenders. It is not an offer of credit. You will still need to apply for the loan and meet the lender’s lending criteria.
The information contained in the home loan key facts sheet includes:
- A description of the loan including the repayment method, repayment frequency, interest rates, and personalised comparison rate;
- Estimated cost of the loan including the total amount to be paid back, establishment and ongoing fees, and the repayments;
- How your repayments will change at the end of the fixed rate period;
- How your repayments will change if interest rates increase; and
- How you can repay your loan faster.