Choosing the right home loan is one of the most important decisions a home buyer will make. With interest rates rising again in June as part of the Reserve Bank’s efforts to curb inflation, it is more important than ever to find the right loan. A home loan is a long-term debt, so even a small difference in the interest rate will add up over time.
There is a lot to consider when hunting for the best home loan rate. A top priority should be avoiding mortgage stress, which is when a household is spending more than 30% of pre-tax income on home loan repayments. The consequence of defaulting on a mortgage is serious. Along with incurring significant financial penalties, there is the possibility of losing the roof over your head and not being permitted to obtain another mortgage for several years.
For some people, a flexible loan that allows for faster repayments is important because the savings can be substantial. Peace of mind is also important, but these kinds of “extras” all come at a price. Weigh up whether these bells and whistles are worth the additional costs and always keep interest rates front of mind.
In the past the big four banks in Australia — ANZ, Commonwealth, NAB, and Westpac dominated the home loan landscape, but now the field is awash with a range of lenders, including online lenders Athena and Nano.
- Firstly, How Much Deposit do you Need?
- Grants for First Home Buyers
- Saving Up and Getting Pre-Approval
- Three Levels of Home Loans
- Paying the Interest Off
- Principal and interest loans (P&I)
- Interest-only loans
- Variable rate home loan
- Fixed home loans
- How to Compare Home Loans
- Interest rate
- Comparison rate
- Monthly repayment amount
- Annual fees
- Are there Additional Features?
- Paying off your loan faster
- Find the Best Home Loan Calculators
- Common Home Loan Fees
- Re-financing or Switching Home Loans
Firstly, How Much Deposit do you Need?
The ideal deposit is 20% of the total value of the home, because a lower amount typically requires Lenders Mortgage Insurance (LMI) to be taken out, and this increases total repayment costs.
It’s possible to obtain a loan with a smaller deposit, but this will increase the amount of interest to be repaid, and monthly repayments may be higher as well. Most lenders use a loan to value (LVR) calculation to determine the amount they are willing to lend. LVR is the amount of the loan as compared with the bank’s valuation of the purchased property. It is expressed as a percentage. If the bank is lending more than 80% LVR, the borrower will generally need Lenders Mortgage Insurance.
Make use of the Government’s MoneySmart home loan calculator to work out your LVR.
Grants for First Home Buyers
The First Home Owner Grant scheme is designed to help people get a foot onto the property ladder. It is a national scheme, but it is funded by the states and territories and each has its own set of eligibility rules and grant size, as outlined below:
- VIC: Grants in regional Victoria are up to $20,000, and $10,000 for everywhere else. First home buyers buying a new or established home valued at $600,000 or less may be exempt from paying the stamp duty tax, while those buying a property of $600,001 to $750,000 may be entitled to a reduction of up to 50%. Eligibility rules apply.
- NSW: Grants are available up to $10,000. New properties valued up to $650,000 are exempt from stamp duty. Properties between $650,000 and $800,000 may receive a partial concession provided eligibility criteria is met.
- NT: Grants of up to $26,000. Concessions on stamp duty are available for first home buyers of up to $23,928.60, but only if they are not eligible for the grant scheme. Those buying a second property or building a new home may receive a grant of $7000. Seniors, pensioners and carers may be entitled to a grant of $10,000.
- Tasmania: Grants of up to $10,000. First home buyers of established homes and pensioners downsizing to new homes may be eligible for duty concessions, depending on their settlement dates and other eligibility criteria.
- QLD: Grants of up to $15,000. There are a range of stamp duty concessions for first homes or for a property that is a principal place of residence, as well as vacant blocks if the buyer has the intention to build. The concession and eligibility criteria differ for each.
- ACT: Grants of up to $7000. A concession is available for a new home or a block of vacant, residential land. The concession is based on a sliding scale in line with property values and eligibility criteria applies.
- SA: Grants of up to $15,000. Concessions on stamp duty are only available for off the plan apartments. The amount of the concession depends on the date of the contract signing.
Saving Up and Getting Pre-Approval
Buying a house is a huge commitment that requires ongoing discipline to repay the mortgage. Saving for a deposit also takes time and most people find that having automatic deductions from their weekly or monthly pay into a separate savings account can help them save.
Once the savings have hit the target goal for the deposit, it is time to apply for loan pre-approval. This means that a lender has agreed, in principle, to lend a specific amount of money towards the purchase of a home. It isn’t full or final approval, but it provides a strong indication of the maximum available funds you can borrow.
It is an exciting part of the process that can also be useful in refining the search and being able to bid with confidence at an auction.
Three Levels of Home Loans
There are three types of home loans: basic, standard and package.
- Basic. As the name suggests, a basic home loan offers a low interest rate but limited features. This may not be the best option for those who may want to make extra repayments and draw on them later, because restrictions and fees apply to doing so. Basic loans are no-frills, which means they have very little in the way of additional features.
- Standard. A standard home loan provides more flexibility than a basic loan, in that it is possible to redraw extra funds paid into the mortgage. There is also the option to switch to a fixed rate or to divide the loan into being partly fixed and partly variable. A 100% offset account is another option.
- Package. A package loan combines a standard loan with an interest rate discount of up to 1.2% depending on the loan amount. This makes it cheaper than many basic loans, however package fees of up to $400 per year may apply. The lender may include a free transaction account or a credit card with no annual fee.
Paying the Interest Off
There are many different ways a homebuyer can structure the loan, depending on his or her needs:
Principal and interest loans (P&I)
As the name suggests, with principal and interest loans your monthly repayments go towards both the interest on the loan as well as the principal, which is the loan amount. Generally speaking, making extra payments toward the principal balance will make it possible to pay off the loan more quickly and reduce the overall cost of the loan.
A P&I loan is often the preferred approach of owner-occupiers, who want to be mortgage-free as soon as possible.
For an initial period, usually the first two years, your mortgage repayments will cover just the interest on the amount borrowed. This means that the debt is not reduced, you are merely chipping away at the interest. While repayments may be lower during the interest-only period, they will inevitably rise, so it is important to make sure that the loan will still be affordable once the interest-only period expires and you are paying off both the interest and the principal.
Many property investors take out interest-only loans because they don’t intend to pay off the home loan entirely. Instead, they flip the property for a profit in a few years’ time. This is, of course, a risky strategy that is entirely dependent on the property market rising year after year.
Variable rate home loan
This is a home loan with an interest rate that fluctuates over time, usually as the RBA raises and lowers the official cash rate.
Pros of variable interest rates:
- You can take advantage of any interest rate decreases, because less interest will be paid on the balance.
- It makes it possible to get ahead on the loan, and pay it off faster, as there is no limit on how many extra repayments you can make.
- It is possible to save on interest because money can be kept in an offset facility that offsets the interest portion of the loan.
Cons of variable interest rates:
- Conversely, if the interest rate increases there will be more interest to pay than the amount agreed at the start of the loan term.
- More uncertainty is associated with this loan type due to its exposure to the movements of the RBA.
Fixed home loans
A fixed home loan is one that is set in stone for a fixed period of time. Knowing the exact amount of your repayments makes it possible to budget with certainty as homeowners will not be affected by RBA interest rate rises. The downside is not being able to benefit if rates fall.
Pros of fixing the rate:
- Many first home buyers prefer to fix their interest rate because of the certainty it provides to their household budget.
- It gives peace of mind, knowing that there won’t be any nasty surprises if interest rates rise during the fixed rate term.
Cons of fixing the rate:
- Not being able to access extra features such as redrawing or making extra repayments that will allow the loan to be paid off more quickly.
- If rates fall, the higher rate will be paid regardless until the end of the fixed rate loan term.
- There are also usually ‘break’ fees or ‘exit’ fees to pay as a penalty for refinancing.
An alternative to making the difficult choice between a fixed interest rate or a variable interest rate is the split loan, also known as the partly-fixed loan. Splitting the home loan is possible at any point during the life of the loan, and it means that a portion of the loan is set at a fixed interest rate and the remainder is variable.
How to Compare Home Loans
There is a range of features to consider when comparing home loans, but among the most important are:
An interest rate is the fee charged for borrowing money of a lender. It is expressed as a percentage of the total loan figure and the goal is to secure the lowest possible interest rate that you can.
A comparison rate includes the interest rate as well as all the fees and charges associated with the loan being administered. The comparison rate provides a picture of the true cost of the loan to the borrower, and can be viewed as a more accurate interest rate in terms of the cost to you. The smaller the difference, therefore, between the comparison rate and the advertised interest rate, the better the deal, generally speaking.
Monthly repayment amount
This is the amount of money that you will need to pay to the financial institution or the bank each month. Spending more than 30% of pre-tax income on your home loan repayments may plunge a house into financial stress so aim for less than this amount.
If the home loan is tied to special discounts under a package home loan, the lender may charge an annual fee. Be sure that you are comfortable with this amount.
Are there Additional Features?
It is also a good idea to investigate what additional features you may benefit from, such as an offset account where salary and savings can be deposited to reduce the amount owing on the home loan, as well as whether you can make additional repayments without incurring a fee.
Equally, you may wish to look into whether the loan includes the option of a repayment holiday that allows home loan repayments to be paused during a period when it would be difficult to make them, such as job changes or a short-term injury. During the Covid-19 lockdowns, many banks offered repayment pauses to customers who needed it.
Paying off your loan faster
The term of a loan is typically 25 years or 30 years. Those five years can make a big difference to the amount that needs to be repaid every month. While it may seem advantageous to pay less each month, in the long run it actually adds up to more because you end up paying more in interest.
Choose the shortest loan possible without causing financial stress. That may be 15 years or it could be 25.
Find the Best Home Loan Calculators
Perhaps one of the best tools in your home loan arsenal is a calculator, which will help you determine how much you can borrow, what your repayments will be and the difference paying off a little extra each month will have on your loan.
Visit the Federal Government’s Moneysmart site for their dedicated home loan calculators.
Common Home Loan Fees
Fees that may seem small at the time of buying a property will add up over the lifetime of the loan, so make sure you’re aware of the true cost of all the fees. Some of the most common mortgage fees include:
- Exit fees: A one-off fee that can be incurred when a loan is ended before the end of its term.
- Redraw fees: Redraw fees are charged by the lender when the borrower takes money back out that was paid into the mortgage.
- Break fees: A break cost is a fee that compensates the lender for its loss if the loan is repaid early or the borrower changes the product, interest rate or payment type during a fixed-rate loan.
- Account-keeping fee: These are ongoing fees that are charged to cover some or all of the lender’s internal costs of administering the account.
- Lender’s mortgage insurance: Lenders Mortgage Insurance (LMI) is insurance that a lender takes out to insure itself against the risk of a borrower being unable to meet their loan repayments and the house being sold for less than the outstanding loan balance.
- Valuation fees: cover the cost of property assessment undertaken by a third-party valuer to determine the value of the property.
Re-financing or Switching Home Loans
A refinancer is someone who switches from one home loan to another. It could be a completely new lender or the same one, and the savings made can be substantial. It is worthwhile keeping an eye out for better options, because the home loan market is constantly evolving its products and features, and often offers a better deal to new customers than existing ones. It’s also important to ensure you’re not paying for loan features you don’t use.
There are many different reasons to refinance a home loan. It may simply be a way of taking advantage of a more competitive rate, or it may be to swap from a fixed to a variable rate, or to borrow more money to make home renovations.
ASIC offers some expert guidance on how to switch lenders, but before you do, it’s always worth contacting your lender and asking for them to lower the rate or match an introductory rate. You can make it clear that you are looking to refinance and ask the lending department for their best rate. They may be prepared to meet your needs rather than lose a valuable customer.