There is always a better option
Find out which home loan is right for you
Types of Loans
Home Loan Options
Which one is your best option?
Remember, the different types of home loans each have various features that appeal to different borrowers. The key is to have the type of home loan that is right for your circumstances.
When considering a home loan, there are various loan types to choose from, such as variable interest rate loan (standard and basic), fixed interest rate loan and Line of Credit (equity loan). See below for detailed descriptions for each type of home loan.
Bridging Loan
A bridging loan, or bridging finance, is a short term loan that finances the purchase of a new property while you are selling your existing property. Bridging loans can also provide finance to build a new home while you live in your current home. You will normally have 6 months to sell the existing property; or 12 months if a new property is being constructed.
How it works
The minimum repayments on a bridging loan will generally be calculated on an interest-only basis, and in many cases this interest may be capitalised until the existing home is sold – that is, accrued and added to the Peak Debt.
Once you sell your first property, the net proceeds of the sale (sale price minus any sale costs such as selling agent’s fees) are used to reduce the Peak Debt. The remaining debt then becomes the End Debt, which is repaid as a standard mortgage product from this point onward.
What happens after the sale of your property?
Advantages
1. Interest capitalisation
If your servicing capacity is not quite enough to cover the repayments on both properties, a bridging loan with an interest capitalisation feature may be a suitable solution, to allow you some financial breathing space while you wait for the sale of your existing property.
2. 100% loan on the new property
A bridging loan can allow you to borrow up to 100% of the purchase price of your new property, plus the associated costs. This is particularly useful if you’ve purchased a property that is outside of your current borrowing capacity, but will become affordable once you’ve sold your existing property.
Construction Loan
Construction loans, also known as owner builder loans, are different from regular home loans, due to building works requiring ongoing payments as the construction progresses. In the case of a traditional home loan, the totality of funds will be made available in a single lump sum, while a construction loan lets borrowers draw on the loan balance when payments need to be made to the builder. These payments are made at key stages of the building process, and are known as progress payments.
How it works
While work is still in progress, you will only be asked to make interest repayments on money that has been drawn down. This means you will only be paying interest on money that has been used. Therefore, repayments will be smaller at the start of your loan, and will increase gradually as your construction project approaches completion.
In general, construction home loans have a variable rate, with a maximum Loan to Value Ratio (LVR) of 95%. This varies depending on lenders, therefore, it is something worth speaking to your mortgage broker about. Lenders also often set a maximum time frame for the complete draw down of your loan, usually around 6 months. If you are not planning to start building right away, you may need to purchase the land on a separate land loan.
Advantages & Disadvantages
Competitive variable interest rates
Requires a fixed price building contract
Facility to draw money whilst building
Possible fees for withdrawals whilst building
Interest only payments during the building period. Because you’re only making the interest payments on the loan, your payments will be substantially lower. This can be very beneficial if the construction is taking longer than anticipated.
Possible penalties for delays – Construction loans are generally for a specific amount of time. If there are delays and the house takes longer to build, you may have to pay penalties.
Additional payments can be made
Repayments will increase if interest rates go up
Fixed versus Variable Home Loan
Variable rate home loans tend to be more flexible, with more features (e.g. redraw facility, ability to make extra payments). Fixed rate home loans are not as flexible and have predictable repayment amounts over the fixed term whereas, variable rate home loans do not.
If you get out of (“break”) a fixed rate home loan term, you will usually be charged significant extra costs.
Fixed Home Loans | How it works
Fixed home loan interest rates could be termed predictive. That is, lenders look at the cost of holding money at a certain rate for a certain amount of time, and determine the interest rate accordingly.
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 1 and 5 years.
Once a borrower has locked in their fixed rate, they will start paying the fixed interest rate straight away.
For example, if a borrower fixed their loan today at a five-year fixed rate which is 2% higher than the variable rate, the borrower would start paying an extra 2% interest right away.
Fixed Home Loans | Advantages & Disadvantages
Repayments do not rise if the official interest rate rises
Repayments do not fall if rates fall
Provides peace of mind for borrowers concerned about rate rises
Allows only limited additional payments
Allows more precise budgeting
Penalises early payout of the loan
Variable Home Loans | How it works
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.
Variable Home Loans | Advantages & Disadvantages
Variable home loans are more flexible
Fewer or different features
Lower monthly repayments.
Fees for additional features
Variable home loans are generally more flexible than fixed alternatives, and often come with some useful features that can be used to make paying off your loan that much simpler
The level of financial uncertainty associated with them. Because variable home loans are tied to the cash rate, the amount of interest you need to pay is more or less at the mercy of wider economic conditions outside of your control
Interest Only Loan
Some people might view an interest-only home loan as an attractive choice when considering finance options for a home. However, interest-only loans were designed with very specific types of borrowers in mind, and that may not be you.
If you are considering an interest-only home loan, it’s vitally important to weigh up some pros and cons of this type of loan. With an interest only loan, you will only be paying off the interest for a set amount of time. So, what’s the catch?
How it works
An interest-only home loan is a type of home loan where you only have to make payments of the interest on the loan for a set period of time. You don’t have to repay the principal on the loan (the loan amount) like in a principal and interest (P&I) loan.
Interest-only loans typically have a maximum period of 5 years, after which the loan reverts to the normal principal and interest repayments.
Instead, interest-only loans can be useful for property investors who can claim the interest as a tax deduction, first home buyers trying to make their first year of loan payments more affordable after the initial upfront expenses of buying, or buyers who only plan on holding onto the property for a few years before selling it.
Advantages & Disadvantages
Lower repayments initially so you have more money to renovate/improve the property.
There will be sudden increase in repayments at the end of the Interest Only period and the loan converts to Principal and Interest repayments.
Cuts the cost of buying a residential investment property in the short-term, which could allow you to make greater contributions to your principal place of residence.
Lenders will assess your ability to repay the loan only on the principal and interest repayments. This can reduce your borrowing power, as these repayments will be higher than a loan on Principal and Interest for the full term.
An interest-only home loan generally presents potential tax benefits to investors. If the interest paid on the home loan is a tax deduction the investor can claim, then paying interest-only maximises that deduction for the investor.
Property might depreciate. Another risk with interest-only loans is that if your property loses value while you are not repaying any of the principal, then you could end up owing more than it is actually worth, possibly requiring you to sell for a loss.
Additional payments can be made
Repayments will increase if interest rates go up
Introductory Loan
Some lenders will offer home loans with a particularly low interest rate for a short period at the beginning of the loan term – to attract borrowers. Also known as a honeymoon rate, this rate generally lasts only for around 12 months before it rises and reverts to standard variable rates. Essentially, it’s a discount that is applied to the interest rate for a period of time. Usually applied to a variable interest rate, the discount is applied to the rate throughout the promotion period.
For example, a current introductory offering is a 1% discount on a lender’s standard variable rate. The standard variable rate is 4.59% and the 1% discount brings the rate down to 3.59%.
Advantages & Disadvantages
Usually the lowest available rates
Payments usually increase after the introductory period
When payments are made at the introductory rate, the principal can be reduced quickly
Once the discounted period ends, the standard variable rate will apply and is often much higher
Some lenders provide an offset account against these loans
Good discounts are often only offered to owner occupiers on principal and interest repayments
Popular with First Home Buyers as the low interest rate can help you get ahead financially during the discounted period
Some lenders may cap or limit the amount of extra money you can pay off the loan during the introductory period
Check exit, break costs or period of restriction/penalties with the loan as you may want to refinance once the introductory discount expires
Line of Credit Loans
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.
How it works
A line of credit is an ongoing agreement between you and your bank which gives you access to a predetermined amount of credit whenever you need it. With a line of credit home loan, any money you borrow is usually secured against the equity in your home.
Say you borrow $300,000 from a bank to buy a home, with a deposit of $50,000. That means that at that point, your equity in the home is $50,000. Ten years later, your debt is down to $170,000 and your property has increased in value to $450,000. This means that all up, you now have around $280,000 equity in your home. Provided you meet the lending criteria of the financial institution, you may then be able to take out a loan against a proportion of the equity you have.
The most common type of home equity loan is the line of credit, which functions in a similar way to a credit card. You have a pre-approved credit limit and you can borrow as much of this sum as you want, with interest paid on the outstanding balance.
Advantages & Disadvantages
A big advantage of a line of credit is that, due to the fact that you’re using your property as security against the loan, you present a lower risk to the lender and will generally pay a lower interest rate then you would on other forms of debt.
Possibly reduces equity in your residential property. Because your home is being used as equity though, it does mean that if your investments go south, or you manage the loan poorly, you could lose your equity and struggle to repay the loan.
Offers flexibility
Usually higher interest rates than other types of loans
Can help you fund things like renovations, holidays or even investments
Need to be disciplined to make principal payments regularly
Can be very expensive if not used carefully
Low Doc Loans
A low-doc or no-doc mortgage is ideally suited for investors or self-employed borrowers looking to refinance, purchase or renovate.
Low Doc home loans are often perceived as higher risk by the lenders, because the income of the borrower cannot be substantiated by conventional means. As a result, a Low Doc loan would usually have a higher-than-average interest rate, plus more limitations in terms of the maximum Loan to Valuation Ratio (LVR), available loan features and package discounts.
How it works
If you cannot provide the types of documents required for a full doc loan – such as company financial statements and tax returns – you can provide essential information through other means, such as a declaration from your accountant of your income or 6 to 12 months of bank statements. In this way, you demonstrate that you can service the loan.
Lenders consider low doc loans as higher risk for them, so they may attract higher interest rates and charges. Some lenders also require a larger deposit, though that larger deposit may result in a lower interest rate.
A common scenario is for business owners to use low doc commercial loans to buy the premises that they’re renting. But they may have difficulty showing proof of their income. For example:
- Small business owners, freelance contractors and self-employed workers who may not have proof of a steady income.
- Businesses that receive much of their income in the form of cash which doesn’t show up in tax returns; their income would appear insufficient for servicing the debt.
- Businesses who want to move fast, but their circumstances have changed since the last tax return, or they don’t have tax returns that are up-to-date.
For a low doc business loan, a lender has particular ways they require you to prove that you have a high enough income to make repayments on a loan.
A lender will also help you determine the best type of low doc loan to suit your needs. In addition to basic low doc loans, there are also line-of-credit low doc loans and fixed-rate low doc loans.
Requirements for a low doc loan
- Self-declared income
- A registered ABN (at least 12 months old)
- A clean credit history
- A good repayment history for previous or existing loans
- Bank account statements and/or BAS statements may be required in some situations
Advantages & Disadvantages
Low Simple income declaration form
They may require a much higher deposit – Because borrowers who require a low doc loan are perceived as a higher risk, you may be asked to pay a considerable amount of money down.
No tax return or financial records required
Higher than traditional loans – Again, since low doc home loans are seen as riskier; the offered interest rate will be more than that of traditional loans.
Fully serviceable loan options, redraws, line of credit, variable or fixed rates
May be subject to fees – Some home loans lenders attach additional fees to their low doc loans; these fees can be for applications and other processing fees.
Principal & Interest or Interest-only loans
Split Rate Loans (Principal & Interest)
A split rate loan lets you divide your home loan between fixed and variable rate components. A split mortgage, or a split rate home loan, is a loan feature that allows you to split your home loan into multiple loan accounts that attract different interest rates.
A popular example for this is to split the home loan into a variable interest rate component and have the rest of the loan amount fixed. The fixed component effectively allows you to manage the risk of interest rate fluctuations.
At the same time, you can take advantage of rate cuts with the variable portion. You can allocate as much as you want to each account as long as it’s allowed by the lender.
How it works
Let’s say that you borrowed $500,000 over a 30-year term and fixed $300,000 at 3.90% per annum for 3 years and kept the remaining $200,000 variable at 3.59%.
Your fixed monthly repayments would be around $1,415 and your variable repayments would $908, bringing your total repayments to $2,323 per month.
After 6 months, your lender increases its variable rate to 3.79% p.a., bringing your total mortgage repayments $2,345, or an increase of $22 per month.
If you were instead to keep your home loan entirely variable, your repayments would have increased from $2,270 to $2,327, or an extra $57 per month.
Similarly, if the variable rate were to decrease to 3.40% p.a. on your split loan, your total repayments would decrease to $2,301, saving you $22 a month.
Advantages & Disadvantages
Security: The fixed rate portion of the loan allows you to manage the risk of interest rate fluctuations. This protects you against sudden rises in interest rate.
Missing out on potential interest rate drops on the fixed component of the loan. Paying more on the variable component if the interest rates rise.
Flexibility: The variable component is the more risky side since there is the risk of an interest rate rise. However, the flexibility of this portion allows you to take advantage of potential decrease in interest rates.
Additional fees, such as account-keeping costs may be charged on both the fixed and variable sides.
Competitive rates: You can get a competitive interest rate which can be secured with the fixed rate, while retaining the flexibility on the variable side.
You may be charged a break cost on the fixed term portion if you pay out the mortgage early.
Offset Facilities
Offset accounts and redraw facilities are both common home loan features, but do you know the difference between them?
Many home loans these days have offset accounts and redraw facilities. In fact even in terms of fixed rate loans many providers are now offering either an offset account of a redraw facility.
At the same time, you can take advantage of rate cuts with the variable portion. You can allocate as much as you want to each account as long as it’s allowed by the lender.
An offset account is...
A transaction account which is linked to your home loan and which has normal transaction account functionality. The benefit is that the money in your account is offset daily against your loan balance, and this will reduce the mortgage interest charged accordingly. While most offset accounts will offset your loan balance in full, some only offer a partial offset.
Example:
Offset Case Study:
Jenny and Mark owe $500,000 on their home loan. They recently won a $10,000 cash prize in a competition and decide to put this $10,000 into the full offset account linked to their home loan. For the period of time the offset account’s balance is kept at $10,000, interest would be charged on only $490,000 of their home loan.
A redraw facility is...
A feature which enables borrowers to withdraw money they have already contributed to pay off their loan. The balance of this facility consists of whatever extra payments the borrower has already made towards paying off their loan.
In many ways, redraw and offset facilities are quite similar. The main difference is that the money sitting in an offset account remains at call and easily accessible, whereas the money in a redraw facility, while accessible, isn’t available for same-day, at call withdrawal. There may also be a redraw fee associated with redrawing money from your loan (among the usual other home loan fees).
Redraw Case Study:
Jenny and Mark owe $500,000 on their home loan. They recently won a $10,000 cash prize in a competition and decide to put this $10,000 as an additional repayment towards their home loan.
Later, they decide to make home renovations to their kitchen. They decide they want to use that $10,000 they won for this purpose, so they apply to their lender to use the redraw facility on their home loan.
Because the $10,000 was an extra repayment on top of their required monthly repayments, the lender grants them the use of their redraw facility. A redraw fee is charged and when the funds are made available later that month, Jenny and Mark are able to withdraw the $10,000 to start making renovations to their kitchen.
Offset vs Redraw
While diligent savers will benefit from either kind of loan feature, it’s important to note that redraw facilities and mortgage offset accounts are better suited for different kinds of mortgage holders.
You have to decide for yourself if you want to do one of two things:
Reduce the interest on your loan while maintaining day-to-day access of your cash: A mortgage offset account offsets the interest owing on your account, but enables you to have day-to-day access to the cash. A mortgage offset account can be used in a transactional way, so is ideally suited for home owners who want to minimise the interest owing on their repayments, without necessarily paying extra off their principal.
Pay off the loan itself (known as the principal): By paying the money directly into the loan, a redraw facility allows you to make payments towards paying off the principal, rather than simply reducing interest in the short-term interest. This is better suited for those who have a focus on paying off their mortgage earlier.
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