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Applying for a home loan – especially if it’s your first time - can sometimes feel like disappearing down a rabbit hole of lender stipulations, banking buzzwords and confusing options.
Today, Australian home buyers have more mortgage choices than ever. The home loan market is incredibly competitive, so it pays to put in the time to thoroughly research all available options.
When shopping for a home loan, the key is to keep it simple while being clear on the fine print, so you can make an informed decision based on your budget, personal situation and future plans. First, of course, you need to make sense of all that pesky jargon that mortgage lenders love to throw around.
Let’s take a look at how home loans work and explore some of the terminology you should be aware of when searching for the right loan.
Home loan basics
Most of us don’t have the cash on hand to buy a home outright, so taking out a home loan is a normal part of purchasing a property. At the moment, there are about 6 million home loans in progress in Australia, collectively worth more than $2 trillion. The average debt on new loans (less than two years old) currently hovers around the $456,000 mark.
If you’re hunting for an affordable home loan, there’s both good and bad news. On the plus side, interest rates have been falling for the past four decades and haven’t been this low since the 1960s. Counterbalancing this is the fact that our homes are some of the most expensive on earth. Sydney and Melbourne, for example, consistently make those lists of ‘top ten least affordable global cities for buying property’.
Whatever your location and whatever interest you end up paying, the ‘knowledge is power’ rule still applies. The more you understand about how home loans work, the better your chances of saving money along the way. Ultimately, your aim is to get the shortest loan term you can afford along with the lowest interest rate and the most benefits.
Be aware of all fees involved, too. These might include application fees, annual fees, legal fees, settlement fees, exit fees, account-keeping fees and break fees (for fixed-interest loans).
Put simply, a home loan is a loan provided by a lender (typically a bank or other financial institution) that enables you to buy a property. The loan is secured against that property - in other words, if you’re unable to repay the loan, the lender can, as a last resort, legally require you to settle the debt by selling the property. Typically, home loans run for terms of between 10 and 30 years, depending on the loan type and agreed-upon monthly payments.
Principal and interest
A home loan is made up of two parts – the principal and the interest. The principal is the total amount you’re borrowing, and the interest is the fee charged by the lender for borrowing that money.
Interest rates are calculated as a percentage of the loan amount. Once you’ve been approved for a home loan, you normally start paying back both the principal and the interest.
The interest paid on your home loan is influenced by a few different factors, including:
- The loan amount –The more money you borrow, and the longer the term of the loan, the more interest you’ll repay over the term of the loan. For example, 4.5% of $500,000 is $22,500 in the first year while 4.5% of $900,000 is $40,500 in the first year.
- Repayment amounts and their frequency – The more frequently you’re able to make repayments, the less interest you’ll pay on your home loan over time. If you’re in a position to make extra repayments, you can reduce your total interest payments even further. For example, if you pay $2,500 per month, your repayment will be $30,000 per annum compared to $625 per week which would see you repaying $32,500.
- The RBA’s official cash rate – Interest rates on home loans are based on the official cash rate set by the Reserve Bank of Australia (RBA). These rates are set on the first Tuesday of each month, with the exception of January. Typically, an increase in the cash rate may lead to a hike in lending interest rates, while a drop can prompt lenders to lower their interest rates.
- Whether your loan is linked to an ‘offset account’ – Some home loans come with an offset account, which allows you to offset the total principal against the funds in the offset account. For example, if your loan is $450,000 but you have $90,000 in a linked 100% offset account, you’ll only pay interest on $360,000 (more on offset accounts later).
- Your home loan's outstanding balance - As you gradually pay off a mortgage, the principal decreases, so you begin to pay a little less interest as time passes.
Different types of home loans
In respect to how interest rates are worked out, the three most common home loan types in Australia are (a) fixed-rate, (b) variable rate and (c) split. Let’s look at the pros and cons of each:
- Fixed – With a fixed-rate loan, repayments and interest rates are locked in for the term of the loan or specified term. Therefore, you always know exactly how much you need to pay, fortnightly or monthly.
Fixed-rate can be a sensible choice if you believe interest rates are likely to rise but conversely, you could end up paying more if rates drop. One potential disadvantage of a fixed-rate is its rigidity: you can’t always pay off your loan when you like. As of November 2020, the average two-year fixed-rate for owner-occupiers was 2.48%.
- Variable – A variable rate home loan involves paying an interest rate that varies depending on changes to the RBA’s official cash rate, changes made by the lender or fluctuations in market interest rates.
Variable rates are a popular option in Australia because of their flexibility: they usually allow you to make additional repayments to pay off your debt more quickly and may include the option of redrawing those additional funds if you should need them in the future. As of November 2020, the average variable home loan rate for owner-occupiers was 3.34%.
- Split – A split home loan is a combination of the two types above: you’ll pay part of your loan at a fixed-rate and the rest at a variable rate. This means you’ll benefit if rates go lower but still have some protection from rising rates. Because you can set the fixed and variable component to suit yourself, there’s a bit more certainty with payments and a level of flexibility.
What is a bridging loan?
Quite often, a buyer might be waiting for the sale of their current property to go through before they can buy a new one, or a seller may put their home on the market with the intention of buying another property straight away. If the existing properties are still carrying a mortgage and selling them won’t happen until after settlement on the new home, things get a little more interesting.
A bridging loan enables you to bridge the gap in paying for a new home before you’ve received the money from selling your existing one. How this typically works is that the lender takes security over both homes until the existing home sale has gone through.
So, is a bridging loan a good idea? Well, that depends on your situation. The main plus in getting a bridging loan is convenience - it lets you jump into a new home immediately without waiting for your present abode to sell. However, there are obvious downsides, too. Bridging finance is an additional loan on top of your home loan and may cost more than you’d like for several reasons:
- Interest on a bridging loan is normally charged monthly, so the longer it takes to find a buyer for your old home, the more interest you’ll pay
- Bridging finance might necessitate two property valuations (existing and new home) and therefore two valuation fees, not to mention any additional fees for the extra loan
- If your existing home doesn’t manage to sell within the prescribed term of the bridging loan, you could end up paying a hefty amount of interest or even have the bank step in to sell your home
- If the house you’re buying requires a substantial home loan and you sell your existing home for much less than anticipated, you could be saddled with a larger-than-expected home loan amount and extra financial strain
Three ways you might avoid the need for a bridging loan are (a) to wait until the money comes through on your old house before purchasing a new one, (b) to put a ‘subject to sale’ clause in the contract for the new house and/or (c) to negotiate a longer settlement period for the new home, which allows you more time to sell the one you’re still living in. If you do decide to explore the prospect of bridging finance, consult a financial professional first to ensure it’s the right choice for you.
Construction loans: building your new home from scratch
If you’re building a new home, one option worth considering is a construction loan. This is a special loan type that allows you to draw money from the principal. Basically, you are borrowing in chunks that roughly correspond with the main stages of building.
Dwelling construction is typically divided into five stages: land purchase, the pad (floor), the roof (normally including frames), lock-up and final work. As each phase of the build is completed, you can access the next portion of the loan to finance the next phase. A valuer normally makes the determination that a particular phase has been completed.
With a traditional home loan, redraw funds are made available as a single lump sum, but a construction loan is structured so you only draw out necessary funds (called progress payments) for the builder at key stages of the construction process. While building is progressing, you only pay interest on the money that has been used.
Construction loans generally have a variable rate. It’s definitely worth shopping around between lenders for the best deal. The lender will often set a maximum time frame for the total ‘draw down’ of your loan – normally around six months or so.
Deciphering home loan jargon
In researching the world of home loans, you’ll run across several terms that can be quite handy to know. Here are some of the most common:
A comparison rate is a rate that helps you compare ‘apples with apples’ when shopping for a home loan. By law, all home loan lenders in Australia must disclose the comparison rate.
The advertised interest rate (also known as the headline rate) on a home loan is just that: the interest alone. However, the comparison rate includes the interest rate plus most of the fees and charges that must be paid over the term of the loan. When weighing up loan options, always look for the comparison rate - it’ll give you a better indication of a home loan’s true cost. Online comparison rate calculators make the search for a home loan easy: you just plug in the required information and the computer formula does the rest.
Equity is how much your home is worth, minus how much you still owe on your home loan. The further along you are in paying off your loan, the more equity you have; you own a bigger share of your property than before.
Most standard home loans are ‘principal and interest’ loans - your regular payments pay down the loan amount while simultaneously covering the interest. With an interest-only loan, however, you pay just the interest for an initial period (typically 1-5 years).
Although this means lower repayments at the beginning, you’re not paying off the principal you borrowed, and your repayment amounts will go up after the interest-only period is finished.
This type of loan uses the lowest available interest rates to attract borrowers. Unfortunately, these low ‘honeymoon rates’ often don’t last past the first year, when they revert to standard home loan rates. The more payments you can make at these introductory rates, the more quickly you’ll reduce the principal.
Line of credit loan
This type of loan is based around the built-up equity in your property and allows you to access funds when needed. Although it offers a flexible way to get your hands on a timely cash injection, it can also reduce the equity in your home and usually involves higher interest rates than a standard home loan. A line of credit loan can potentially end up costing you more than expected if you’re undisciplined about making regular repayments on the principal.
LMI (Lenders Mortgage Insurance)
LMI is insurance that protects the lender if you default on your home loan. If you’re borrowing more than 80%of the property’s purchase price, there’s a good chance the lender will require you to pay for a Lenders Mortgage Insurance policy, since their risk is increased.
Lenders base this insurance on the loan-to-value ratio (LVR): the loan amount as a percentage of the home’s value. For example, if you’re borrowing $450,000 to buy a home valued at $500,000, your LVR is 90%.
More on LMI can be found reading ‘What is lenders mortgage insurance (LMI)’
This loan type is popular with self-employed people or those who haven’t been in their current job for long, and therefore find it tough to provide the documentation required for a standard home loan. As the name suggests, less paperwork is required but you can expect to pay higher interest rates and fees.
Aspiring home buyers with a poor credit rating may have a hard time being approved for a standard home loan because they pose a greater risk to the lender. For them, a non-conforming loan may be worth exploring. Here, the interest rate is based on the state of the applicant’s credit history and a larger deposit is usually required to secure the loan.
This is a separate account in which you keep money to ‘offset’ your loan amount. The balance in your offset account works daily against your principal. For example, if your total home loan is $380,000 and you’ve got $30,000 in your offset account, you’re only charged interest on $350,000 ($380,000 - $30,000). Offset accounts can be a wise place to stash any extra cash you acquire.
When you make extra repayments on your home loan above and beyond what’s required, a redraw facility allows you to take that money out later. The withdrawn amount is then added back on to your home loan balance.
This is simply taking out a new home loan to replace the one you started with. You might do this to take advantage of better interest rates or to access more advantageous loan features with another lender.
Most often available to older Australians, reverse mortgages make it possible to convert part of a home’s built-up equity into cash. Reverse mortgages can be complicated, however, so you’ll need to get independent financial or legal advice before you go ahead.
Quick tips for home loan success
- Compare home loan options from at least three lenders, using the comparison rate rather than the advertised (headline) rate
- Try to save up a deposit equal to or greater than 20% of the property’s value; a bigger deposit means a smaller, more manageable home loan, greater immediate equity and the possibility of sidestepping the requirement for Lenders Mortgage Insurance
- Give yourself some wiggle room with the amount you borrow – interest rates and personal circumstances can change, so allowing some financial breathing space can help you manage the unexpected
- Seek out the lowest interest rate possible: even a tiny fraction of a percentage point can make a substantial difference over the course of a 25-30 year home loan
- Don’t forget that although your home loan is the biggest expense in buying a new home, it’s not the only one; there are also expenses such as stamp duty, legal fees, valuations, building/pest inspections, moving costs and more
- Making fortnightly rather than monthly payments and using any spare cash to make extra repayments can help pay off your loan a little more quickly
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