When it comes to your finances and in particular the biggest purchase of your life it is really important to understand the different type of Mortgages or Home Loan packages available to you. There are multiple terms, industry jargon and different options to get your head around and it can be a real minefield to navigate.
Over this article I want to impart what I have learnt and break down what the most common terms mean as well as what types of structures could work for you! A great starting point is reading “What is a Principle Home Loan vs. Interest Only” this will break down the fundamentals of a mortgage.
So what exactly is a Home Loan and how does it work (or any loan for that matter – these principles apply for Personal Loans, Credit Cards, Line of Credit etc. too)?
A loans interest is calculated daily by the remaining money owed (principle) whilst also being compounded; then added to the loan at the end of every month. This will fluctuate by the amount of days in the month; this is why sometime you’ll see the amount of interest will be more or less on your statements.
It’s also worth exploring how are rates determined quickly: The RBA (Reserve Bank of Australia) meet every 1st Tuesday of the month and look at the overall economy and how it is tracking. They examine how the housing sector (Core Logic Index) is tracking vs Banking Sector vs GDP vs Wage Growth vs Population Growth vs Consumer Index vs Business Sector and also the targeted Inflation percentage. You can see that they really do look at the bigger picture before making any decisions. But in essence they are trying to achieve a balance of sustained growth rather than that of sporicidal or rapid growth helping keep the Australian dream of owning their own home a reality.
So let’s look at what the different terms mean:
Principle:
Principle is the total amount you need to borrow to acquire a particular item. In this case it will be the house or land (property). It’s worth noting though that in the case of a small or personal loan it could be the total of the car, renovation or holiday amount required.
Interest Only:
If you have chosen this option then every time you make a mortgage payment the whole amount will only be towards the interest component with no amount paying down the principle. This will continue until your chosen period has finished and the loan will automatically default to Variable. Again for more on this read “What is a Principle Home Loan vs. Interest Only”.
Fixed Interest or also referred to as Fixed Rate:
Is a loan where you pay both the Principle and Interest on the loan over a predetermined time frame. The period is usually either 1,2,3,4 or 5 years and different rates apply for each time frame offered. The rate is as the name suggests fixed for that period of time. It is a great option if you are running a tight budget. Another common reason people fix for a term; is that they are hedging against the economy and just in case interest rates rise.
The disadvantages of a fixed loan is that if you need to sell, refinance or top up the loan (to consolidate debt or use equity to purchase a car/another property etc.) you will need to pay usually quite high break fees. This is because you have entered a contract to pay $XXX amount back of the time frame chosen. Break Costs are calculated daily by the remaining days left and will vary. It is for this reason really you should take into consideration “Am I going to need to do something with this loan?” Before fixing you loan.
Variable:
Completely opposite to the Fixed Rate/Fixed Interest loan these rates are not locked in and fluctuate with current economic cycles and events. This rate is attractive when the economy is not doing so well and ideal for paying down that principle debt quicker.
Pro’s for Variable is that you can pay back as much and as quickly as you like with NO penalties for doing so. You can access equity, refinance and even top up with no break costs being incurred.
Con’s for Variable is that you are very exposed to the market. Therefore if interest rates rise then so could you Home Loan if your chosen institution chooses to do so.
Line of Credit:
Think of this like a Credit Card (in principle) and also commonly referred to as LoC’s (Line of Credit) in the industry. Line of Credit’s are secured by your property (registered against your Title) just like a Home Loan. The interest rates on LoC’s are always higher as there is more risk to the lending institution.
So just like a Credit Card you will only pay interest on the money you spent! For example you have a Line of Credit limit of $60,000 however you have only spent $12,000, therefore you will only be charge interest on the $12,000 (not the whole $60,000) until you have paid back the balance to $0.
They can be handy in certain circumstances like a small business where you have 30 day accounts for goods that you are waiting on payments for, and cash flow can be a little up and down. The LoC will give you the benefit of having on demand cash when periods are a little tight. But be wary and always pay them down! It’s easy to get into the trap of the revolving debt!
Redraw or Redraw Facility:
Check with the institution you are lending from as this loan feature can be very handy! Not to be confused with an Offset, the Redraw is purely when you get ahead on your Home Loan!!
With this facility whenever you make an extra repayment towards the Principle (again total amount owed) then your home loan will show that you are ahead in payments. This amount you are ahead of you can typically as the name suggests “Redraw” and use as if they were savings. Now I’ll add if you make your home loan repayments more frequent than monthly; that is whether fortnightly or weekly you will automatically be paying ahead – as the very nature of repayment frequency you will automatically make at least an extra 2x payments in that year. Therefore automatically by default have redraw available.
Again check with your lending institutions as some have a limit that you can take out. For example they require to take out lump sums in $XXXX amounts or to leave $XXXX amount just in case you get into hardship etc.
Also check with your lending institution if the extra repayments actually come off the remaining principle? What I mean by this is if you do not need the say $8,000 you have paid for in advance? You can what is called “Capitalise the Payment or Facility”. This then closes the redraw amount and reduces the principle. The downside of doing this is that you need to start the redraw accumulation process all over again.
Pros of Redraw;
Is that if something unexpected happens like your hot water system going then you can pay for the repairs or new system without having to apply for a Personal Loan, dipping into saving or putting on higher interest such as Credit Card etc. Redraw is also great if you are planning on having a baby and have limited cash/paid maternity leave available to you. For example if you want to take a whole year off and only get paid for 6 months, if you are ahead by 6 months repayments you can simply let the repayments come out of the Redraw!! How good is that! I will point out though you will be back in the same place as you first started and also check with your lending institution that they will allow this. 🙂
Cons of Redraw;
Do not fall into the trap of using regularly for items that either depreciate (like cars etc.) or spending sprees…after all you’ve worked hard to reduce your debts and only to increase your loan again will only increase your repayments (in some cases) or put you back to the remaining term (instead of paying off sooner).
Split Loan:
This is as the name suggests is when you split your loan and keep one portion Variable and Fix the remaining portion. This is handy in cases where you want to hedge your bets against the economy and the possibility of interest rate rises.
Commonly used when you have also borrowed towards your maximum borrowing capacity and for budgeting purposes need to make the repayments cheaper. You may fix 80% leaving 20% on variable to try and reduce as quickly as possible; others do a 50/50% split. Also common in Parent Guarantor loans where the loan against the kid’s house is fixed and the loan against the parent’s house is variable. There is then a concentrated effort to pay off or extinguish the debt on the parents’ house as to release their obligations and free up their home.
Refinancing:
This is when you as the name suggests refinance the entire loan for either; cheaper rate, better features, different institution or restructure the way the loan is. You may also refinance when you are looking at buying a new/additional property like an investment/holiday home/land, upgrading or downsizing properties.
Top Up:
This is a common phrase when you use the equity in your home and extend the Principle (total amount owed). Then use the proceeds for a new car, renovations, holiday, boat, investment property and list goes on.
It is also a common misconception that it is as easy as simply extending you loan…It is not! Under new laws and what has come of the 2017/18 Royal Commission; is that you are now applying for a new loan and must be assessed again as a brand new application for you total overall exposure. Just something to be aware of 😉
Comparison Rate:
Firstly the rate that is advertised or also commonly known as “Carded Rate”. This rate is then compared to by adding to a loan amount over a chose time frame and factors in interest rate and charges as a single percentage rate. This Comparison Rate indicates the true cost of the loan. This rate then can be compared over other institutions.
Offset Account:
Probably the most under utilised and most overlooked product out in the banking sector! Big call I know but the amount of people I talk to and also see not using one is astounding! If you have a Loan whether it be big or small you SHOULD have one!!
After all we all have a bank account where money goes into then disbursed into loans, bills, spending money, savings etc. Why not take advantage of, as Warren Buffet said “the 8th Wonder of the World” COMPOUNDING 🙂
Yes your Everyday Account (or whatever it may be called) that you use charges no fees, and normally has unlimited transfers etc. just for the right to do so? So why not capitalise on saving interest against your Home Loan? Let me also make this perfectly clear that an Offset will give you Zero, Nil, Nothing, $0.00 interest also. Just as your everyday banking account but let it work much harder for you! After all saving interest at scale makes sense right?
So how does it work?… Let us look at a quick example:
If I had a $100,000 loan and I had an Offset Account with say $10,000 in it. As explained at the start of this article interest is worked out daily then added onto the loan at the end of the month. Now if we didn’t have an Offset then the interest is calculated on the whole $100,000. But as we have $10,000 sitting in an Offset account against it the interest is calculated on $100,000-$10,000 = $90,000. So you are saving X.X% (insert your interest rate here) against your loan at the lower amount!!! How good is that!!
Now here is the kicker…what if your pay and everyday transactions are happening in the back ground on top? So one fortnight you get paid $2,500, you now have $12,500, as you pay the bills and live life and as the balance goes down (and up again at pay day) so too is the interest that is calculated daily in the background! Completely priceless 🙂
More on this in our how to reduce your Home Loan quicker scenario below.
Guarantor Loans or also known as Family Guarantee Loans:
As the name suggests it’s a loan that someone has guaranteed in case of default on the behalf of the other party or the borrower. It is a VERY big risk for the Guarantor and a decision that cannot be taken lightly!! In the case of a Home Loan the Guarantor must be a direct relative of the borrower; and must be Parent, Parent In-Law or Step Parent. Your Uncle, Brother, Friend etc. cannot be guarantor.
Parent Guarantor Loans work well when the kids don’t have the appropriate deposit available and the parents own their home out right (or close too). Key being plenty of equity available to secure against. The kids can then borrow the whole 100% plus closing costs to secure and purchase their first home. To reiterate it must be a property they intend on living in and cannot be an investment property.
This is also a handy option so the kids (borrowers) do not pay any LMI (Lenders Mortgage Insurance). The way the loan is structured (bare minimum and is 99% the most common scenario) is that 80% is held over the purchased property. and the remaining amount is secured over the parents (guarantor) property.
It is also a misconception that the only security that is held over the guarantor’s property is the actual 20% plus closing costs. This is completely wrong and just as the borrowers (kids), to avoid LMI (lenders Mortgage Insurance) on the purchased property so too do the same principles apply to the guarantor’s property. So if 80% is the maximum lend on the purchasers property; so too that must be applied to the guarantors property.
Lets look at a very basic example:
Purchase Property = $300,000 (we will use rounded figures and assume all closing cost etc. are included)
Therefor 80% of $300,000 = $240,000 secured against purchased property
So that leaves $60,000 ($300,000 – $240,000) left to be secured against the guarantor property right? Nope we then need to add more security to make it 80%. So if we take that $60,000 divided it by 80% = $75,000 worth of equity is needed. (Note: loan will remain at $60,000 just the equity used will be $75,000)
You can see now that there really is more at stake for the guarantor!
So let’s tie it all together and look at how you to pay that Home Loan off sooner!!!:
If you haven’t already got a budget in place then read the following articles:
- How to create a budget & track your spending – Personal Budget Part1
- Putting your budget to use: saving for a house deposit – Personal Budget Part2
- New Expenses: How to adjust your budget after your first home – Personal Budget Part3
You need to know what your surplus cash flow is, whether weekly, fortnightly or monthly. We can then work out how much we can comfortably pay towards the loan to pay it off sooner 🙂
Now there are a couple of calculators I like to use as with the below scenario.
Mortgage offset calculator from ING:
https://www.ing.com.au/home-loans/calculators/offset.html
But feel free to use any of them out there; I just like this one because it looks pretty 😉
You can see by the below example having $10,000 sitting against the Home Loan of $300,000 at 4.4% variable rate, you potentially save 1 year 5 months off the life of the loan and approx. $25,812 worth of interest. Now what happens if you combine that with even small additional repayments?
Extra Repayment Calculator from BankSA:
So we also know by our budget that we can comfortably afford to pay an extra $70 per fortnight ($35 per week). Which in the scheme of things really could go by unnoticed. So what happens if we apply that to the loan from the moment we take it out?
For this I like the BankSA Extra Repayments Calculator. Again you can play around and adjust to your situation but again we will use the same loan scenario.
https://www.banksa.com.au/personal/home-loans/home-loan-calculators/extra-repayments
So by simply paying an extra $70 per fortnight you would potentially save 8 years and 1 month of the term of the loan or $32,819 in interest. Now if you add this and compound it by the Offset you can see you can really do some damage!!
As you can see by the above example and also the different types of features/products available. I can’t stress enough that finding the right Broker or Banker is extremely important!
The Loan that you choose must work for your needs and circumstances! After all, the word “Mortgage” itself loosely means; “An Agreement until Death”. Not exactly my idea of fun…. and that’s why it is vitally important to understand what you are getting into.
Happy house hunting and don’t forget to visit our “Tips & Blog” page for further information on all things Real Estate! And why not download the FREE “The Property Buyers Guide App” while you’re at it 😉