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Bookmark This Article for Future Reference
There are a variety of home loan options available today. This article explains the features and advantages/disadvantages of the main categories of home loans.
The information in this article is also relevant for those wishing to structure their loan(s) in order to clear their mortgage in the shortest possible time-frame. If that is your goal, this article should be read in conjunction with our article: Mortgage Reduction Tips.
This article comprises several sections: We have a separate article in which we cover Non-Conforming Loans (Sub-Prime lending).
The interest rate on a variable rate loan will vary over the life of the loan in line with the Reserve Bank of Australia’s (RBA) official cash rate, albeit that the rate on the loan will be higher than the RBA’s official rate.
Most of these loans are principal and interest (P&I) loans with a term of up to 30yrs, however one can get interest only variable rate loans. These loans generally fall into three categories.
CONTROLLED/CAPPED RATE HOME LOANS
This type of variable loan allows you to set a "ceiling" rate. If variable rates rise above your pre-determined ceiling rate, say 8%, your rate will be capped at that level. Similarly, if variable rates were to drop back down, or if they were to drop below the prevailing variable rate at the time you took out your facility, your interest rate would follow the variable rate down. This provides you with the best of both worlds, albeit with a premium added to the prevailing standard variable rate for the protection and flexibility you are getting.
Whereas Variable Rates are pegged to the RBA's official cash rate, the key market indicator determining Fixed Rates are bond yields.
A Fixed Rate loan typically allows one the ability to lock in the interest rate for a period of 1 to 10 years on a principal and interest (P&I) basis, or for 1 to 5 years for an interest only facility. The interest only loan is often chosen for investment property purchases as any principal payment on the loan is non tax deductible whereas all interest payments are deductible.
The advantages are:
The disadvantages are:
If the advantages appeal to you but you are put off by the disadvantages, consider a combination loan.
These loans allow for a percentage of the loan to remain on a variable rate, whilst the remaining portion of the loan is on a 1 to 5 year fixed rate. The borrower can nominate the percentage split they want, say 50:50, 60:40, 80:20.
This allows some protection against rising interest rates, but also for extra repayments to be made off the variable portion of the loan without incurring the penalty fees which normally exist when such payments are made on a fixed rate loan. Depending on the provider, you need to watch out that you are not charged two sets of establishment and ongoing fees. A line of credit facility can also be accommodated onto this type of loan depending on the provider.
These type of loans have risen greatly in popularity in recent years. They are predominantly aimed at the self-employed and business owners, but many others are taking advantage of them including casual & contract workers. The appeal of these loans is the fact that borrowers do not need to furnish documentation to the lender to substantiate their income. Borrowers need only sign a declaration stating their income.
It's often best to apply for Low Doc or No Doc loans using a good mortgage broker. They can tell you, before they submit your application to the lender, how much income the lender will likely require for you to qualify for the loan.
These loans also come in all varieties - fixed rate, variable rate, home equity / line of credit type Low & No Doc loans are all available.
INTEREST SAVER/100% OFFSET ACCOUNT
This is typically an every day transaction type account whereby the interest paid to the account is used to reduce the amount of interest calculated on the associated home loan. Generally you would have all your salary paid into this account, as well as hold all your savings within it, in order to reduce the balance upon which interest is charged on your mortgage loan.
Because interest is calculated daily in most cases, you save interest every day with every dollar in your offset account. This is a very effective tool for Mortgage Reduction and can help you cut years off your loan.
However, a word of warning is required. Ensure that the offset account you choose pays the same interest rate as the rate on your home loan. The early version Offset accounts often didn't pay the same rate of interest, and yet were labelled "100% Offset". Technically, the banks were indeed using the interest on "100% of the offset account balance" to reduce interest on the home loan, only they were using a lower rate of interest on the offset account! It’s worth doing your homework on this one – getting the right kind of offset account could save you years on your home loan compared to the wrong type.
HOME EQUITY LOAN / LINE OF CREDIT
A Home Equity Loan, also known as a Revolving Line of Credit, is a transaction account secured by a mortgage over residential property. The applicable interest rate may be set a little higher than that of a Standard Variable home loan. There is no term to Home Equity loans, but typically a minimum monthly payment is due on the outstanding balance (at least equal to the interest which has been charged for the month). In some cases the interest can be capitalised (added to the loan balance) up to the loan limit without a minimum monthly payment being required. The credit limit is typically up to 80% of the value of the property (up to 90% with lenders mortgage insurance), and the funds can be used for any purpose: personal, investment or business.
Depending on the provider, the facility should be able to be split into multiple accounts, with separate cheque books and statements. For example, you could have one split for your home loan, another to finance the equity portion (20%) of an investment property, another for share purchases, and yet another for discretionary spending. This facilitates the calculation of tax deductible interest amounts (for the investment property and shares) as opposed to the non-deductible amounts (home loan & discretionary spending).
All of your income can be credited directly to your Home Equity loan, and this enables you to close all of your other existing bank accounts to save on fees. It can be used in the same way as a standard transaction account, with ATM and EFTPOS access, as well as a cheque book(1), and an attached debit card. As an alternative to a debit card, you can obtain a 55 day interest free credit card and set it up so that the outstanding card balance automatically transfers to the loan at the end of the interest free period.
If managed properly, these are very effective accounts for Mortgage Reduction purposes and can cut years off your home loan. Interest is only charged on the daily outstanding balance, hence the common practice of crediting all of one’s income directly to the account to reduce the daily balance upon which interest is calculated. Living expenses can then be paid for out of available funds within the loan on a needs be basis. For example, one might pay all of one’s monthly expenses with a 55 day interest free credit card and pay off the entire balance of the card on the due date using funds from the Home Equity loan account.
Depending on the provider, other advantages include:
This type of facility can also allow one to consolidate existing personal loans or credit cards into the Home Equity loan, thus saving money by virtue of the lower interest rate on the loan.
Such great flexibility has its pitfalls. One of these is that if you use a Home Equity loan partially for investment purposes and the investment goes awry affecting your ability to service the debt, you could be putting your house on the line - literally! Another example would be if you use it to buy the family car and you become unable to service the facility due to illness or job loss or rising interest rates - it will no longer be the car your banker will come to repossess but your house!
Whilst Home Equity loans can provide disciplined borrowers with the advantage of a vast degree of flexibility in managing their finances, undisciplined borrowers who go out and spend up on depreciating items (car, boat, widescreen TV) can find themselves in a never ending debt trap. In the past, with traditional P&I loans, home owners were forced into gradually reducing their home loan over time. But with Home Equity Loans this is no longer a requirement. Now you can have a new car, or a holiday, etc… and for those who succumb to this temptation, the flip side is that they are likely to find a mortgage remaining on their home even at the age of retirement. For a generation that is likely to see the phasing out of the old age pension, this wouldn’t be a pretty prospect.
100% LVR LOAN (a.k.a. "No Deposit Home Loans")
A number of lenders have recently made available "No Deposit Home Loans" which allow the borrower to finance 100% of the cost of a residential property providing they can meet purchasing costs. Purchasing costs include such items as stamp duty and conveyancing, and typically represent about 5% of the cost of a property.
SENIORS' EQUITY ACCESS LOANS (a.k.a "Reverse Mortgages")
Reverse
Mortgages for seniors, which have been around in the U.S. for quite
sometime, came back onto the Australian market in 2003 through both
the Commonwealth Bank and St. George Bank.
Make a list of all the features that you need for your loan and assign a priority ranking to each. Then go out and do your research with different lenders and use a comparison checksheet to mark those features which are most important to you. If you find you don’t need the bells and whistles available on a Standard Variable, then switch to a Basic Variable with a lower interest rate, maybe up to 1% cheaper.
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This article is: © Copyright 2003-2007, Financially Free Pty Ltd. All rights reserved. Copying or reproduction is prohibited without prior permission.
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