FIXED INTEREST RATE
The interest rate is fixed for a certain period, usually the first one to five years of the loan. This means your regular repayments stay the same regardless of changes in interest rates. At the end of the fixed period you can decide whether to fix the rate again, at whatever rate lenders are offering, or move to a variable loan.
In general, if a lender expects the cash rate to rise, the fixed rate will usually be higher than the variable rate; on the other hand, if the expectation is for the cash rate to fall, the fixed rate will tend to be lower than the current variable rate.
When a borrower fixes the interest rate on their home loan, they are usually anticipating that the variable rate will rise above the rates which they have locked in.
Lenders may offer fixed terms between 1 and 15 years; however, most fixed rate terms are between one and five years.
- Your regular repayments are unaffected by increases in interest rates.
- You can manage your household budget better during the fixed period, knowing exactly how much is needed to repay your home loan.
- If interest rates go down, you don’t benefit from the decrease. Your regular repayments stay the same.
- You can end up paying more than someone with a variable loan if rates remain higher under your agreed fixed rate for a prolonged period.
- There is very limited opportunity for additional repayments during the fixed rate period.
- You may be penalised financially if you exit the loan before the end of the fixed rate period.
INTEREST ONLY REPAYMENTS
An ‘interest-only’ home loan requires a borrower to pay only the interest component of the loan. This structure requires the repayment of the original borrowed amount in a lump sum when the home loan period is complete or the property is sold. Unless the interest only period is extended, the interest-only home loans revert to a principal and interest loan after a set initial period. Usually within one to five years.
Your repayment amount will be lower during the interest-only period (compared to making principal and interest repayments) so the earlier years of your home loan will be easier to manage.
During the interest-only period, you can choose to repay any principal and, if so, how much (but don’t forget to check if this would trigger break costs). If you ever want to redraw money from the extra repayments, you can – provided the option to redraw is available.
Interest-only home loans are more widely used by investors, who are attracted by the tax saving aspects and are usually not likely to hold the property for the term of the home loan. An interest-only home loan works well for investors who want to use the property to generate rental income and capital gains.In addition, you can maximise any available tax-deductible interest and can free up cash flow for other investments.
They are not ideal for owner occupiers who are more focused on building equity in their property, as the underlying home loan debt is not reduced with interest-only.
Be aware though that with an interest-only home loan, there is still the potential for the property to increase in capital value as real estate prices rise, which will have a positive impact on the borrower’s equity.
In the long run, it generally costs more. Interest is charged on the outstanding balance of your loan. So if you don’t reduce your loan by making principal payments, your interest charge will be higher.
More borrowers are moving to include redraw facilities when establishing a home loan, and it is easy to see why. The ability to make extra repayments into the mortgage, instead of putting that money into say, a savings account, allows borrowers to reduce the interest on their home loan, which in turn helps reduce the term of the loan.
It also provides borrowers with a safety net, as they can access the extra payments if required, down the track. This is particularly suited to first home buyers who are not likely to have extra funds in the early stages of their home loan, but may in the future.
It is important to be aware of the costs involved, which may include set up, activation fees and redraw fees. There may also be limits on redraw withdrawal amounts (both maximum and minimum).
SPLIT RATE LOANS
A split rate loan is a loan that has one portion of the loan fixed and one portion variable. You decide on the proportion of variable and fixed. You enjoy some of the flexibility of a variable loan along with the certainty of a fixed rate loan.
- Provides some peace of mind for borrowers concerned about rate rises
- Provides more certainty in budgeting than full variable loans
- Can make additional payments on variable portion
- If the interest rate fall, your regular repayments on the variable portion will too
- Allows limited additional payments only
- Repayments will rise with rate rises
- You will be penalised financially if you exit the fixed portion of the loan early
What is loan portability?
Loan portability is a feature offered on many loans which allows you to keep your loan when moving to a new property, saving you the hassle of refinancing. Usually the term of a regular loan is between 25 and 30 years, so it is very common for people to move houses while they are still paying off a loan. Because moving is becoming more and more common, loan portability is offered with many loans meaning you can move the loan with you. Loan portability saves you the time and cost associated with closing off one loan and applying for a new loan.
While you have the convenience of staying with your current home loan, and you don’t need to pay for bridging or refinancing, there are normally fees attached to using this feature.Refinancing your loan involves time and expensive exit fees, so consider whether the feature of a portable loan would suit your financial and personal situation better. If you’re sure the home loan you already have is the best deal for you, then loan portability may be worth exploring.
How does loan portability work?
When you apply for a home loan you have to pay upfront costs to secure it. These costs can be very expensive and can increase the overall amount you spend on the loan. Because of the extent of these costs, homeowners want to protect themselves from having to pay it again by getting ‘portability features’ within their loans that allow them to transfer the loan to a new property if they decide to move, helping them avoid fees in the future.
VARIABLE INTEREST RATE
Standard variable loans are the most popular home loan in Australia. Interest rates go up or down over the life off the loan depending on the official rate set by the Reserve Bank of Australia, funding costs and the competition in the market. Variable rates are a reflection of the current economic climate. The Reserve Bank uses the cash rate as a blunt instrument to try to control inflation – when inflation is getting too high (typically when the economy is doing well) the cash rate goes up; when the economy is weakening (inflation usually is lower) the cash rate often comes down.
- If interest rates fall, the size of your minimum repayments will too.
- Standard variable loans allow you to make extra repayments. Even small extra payments can cut the length and cost of your mortgage.
- Basic variable loans often don’t come with a redraw facility, removing the temptation to spend money you’ve already paid off your loan.
- If interest rates rise, the size of your repayments will too.
- Increased loan repayments due to rate rises could impact your household budget, so make sure you take potential interest rate hikes into account when working out how much money to borrow.
- You need to be disciplined around the redraw facility on a standard variable loan. If you dip into it too often, it will take much longer and cost more to pay off your loan.
- If you have a basic variable loan, you won’t be able to pay it off quicker or get access to money you have already repaid if you ever need it.
PRINCIPAL AND INTEREST
Principal and interest’ and ‘interest-only’ home loans are designed to give borrowers a choice in the way they make their repayments, and how much and when they repay. Both will suit different borrowers’ needs and circumstances.
A principal and interest home loan requires borrowers to make payments on the interest accrued on the mortgage, as well as repay a part of the principal. In this way, repayments on principal and interest home loans actually reduce your debt. Repayments are calculated and spread out so that the last scheduled payment fully pays out the home loan.
These repayments will be higher than for an interest-only home loan, but they will help borrowers pay off their home loan. If you are planning to buy a property to live in long term, then it is likely a principal and interest loan will better suit your needs.
Repaying both interest and the principal will allow you to gradually increase your equity in the property by reducing the size of your mortgage, and at the end of the loan term you will be the sole owner of your home.
Mortgage offset accounts allow borrowers to use their savings and income to reduce the amount of interest they pay on their mortgage. This works by using the interest that would usually be paid to them on their savings to instead be deducted from (“offset” against) the amount of interest they owe on their mortgage. Furthermore, under this arrangement, as you don’t actually receive any interest on your savings in your hands (that interest is offset against your home loan debt rather than being credited to your savings account), no tax is payable on it. You get the full, tax-free benefit of the savings interest in reducing your home loan debt.
This often operates best when your mortgage offset account is used as your primary bank account – for savings, lump sum payments and salary payments.
Note that offset accounts are more common with variable rate home loans, and are not always available on fixed rate home loans.
Some home loans will offer the same rate of interest on the mortgage and the offset account and these are known as full (or 100%) offsets. Alternatively, lenders will provide able to provide a partial offset.
Mortgage offsets can be very effective if used correctly, but bear in mind that lenders often charge a higher than average rate on the mortgage, usually up to about 0.15 per cent, or may charge additional monthly fees, for the privilege of having this feature. It is important to do your sums, as it might not suit your circumstances, especially if you have a large mortgage and little savings to put in the offset account.
LINE OF CREDIT/EQUITY LINE
A line of credit is similar to having a big chequebook, however with interest accruing on the balance. A line of credit, or equity line as they’re sometimes called, is an approved limit of borrowings that you can use a piece-at-a-time, or all at once.
A line of credit loan facility can be a great way to access the equity in your home and can be used for things like home renovations, investments or other personal purchases. It acts as a loan, but, unlike a loan, a line of credit doesn’t require you to pay interest on the credit you don’t use.
This type of property loan revolves around equity built up in your property and allows access to funds when needed. These products are creative ways to raise funds for investment by providing cash up to a pre-arranged limit. Each month the loan account balance is reduced by the amount of cash coming in and increased by the amount paid on the credit card or withdrawn in cash. As long as there is consistently more cash coming in than going out these accounts can work well. However, they can be very costly if the balance of the line of credit is not regularly reduced. It requires an interest-only payment as a minimum each month, which can add up to a lot of interest over the long term.
– Use the money you need and pay it back when you can
– Home loan interest rates tend to be lower than credit cards or personal loans
– Offers flexibility
– Possibly reduces equity in your residential property
– Usually higher interest rates
– Need to be disciplined to make principal payments regularly
– Can be very expensive if not used carefully
Another product type you’ll find heavily marketed is the ‘professional package’.
Most of the major lenders will offer special packages for borrowers taking up $250,000 or higher, although some form of discounts are available on mortgages from $100,000. Originally designed for higher income earners or borrowers in a specific profession, products and services were bundled up as a special package and the term ‘professional package’ was born (since shortened to pro-pack).
Of course, time has moved on, and just about anyone who can afford it can now access these products, although the term pro-pack stuck. Generally speaking, a pro-pack includes:
- Interest rate discounts on variable rate home loans
- Up to four credit cards with no annual fee
- Free or discounted offset and savings accounts
- Discount on insurances including building, income protection and landlord protection insurances. Some even offer discounted car insurance
- Fee waivers or reductions on valuations, top-ups and switches
The central component is a home loan, which will need to be over a certain amount to qualify, that figure is usually relatively low at around $100,000 for some lenders. The banks will allow you to slot their existing fixed or variable loan products into the pro-pack and give a discount on the prevailing standard variable rate. The discounts range on variable loans are anywhere between 0.1% and 1% depending on the size of the loan – the bigger the loan, the greater the discount.
While pro-packs are available regardless of your loan amount, discounts are often not worth the money for loan amounts below $250,000, due to the high monthly or annual fee you will be required to pay.
Banks tend to offer a wider selection of financial products than non-bank lenders, so the package is designed to attract as much of the customer’s business as possible.