How do home loans work?
Rates and Fees verified correct on September 2nd, 2015
Discover the ins and outs of the one of the most important financial products you’ll ever use.
A small percent of Australians will be able to purchase their first or subsequent homes or investment properties without having to get a home loan. For the vast majority, a home loan will be required to finance the gap between your deposit and the property price.
Getting a home loan basically entails borrowing money and repaying that amount plus any interest charged over a period of time. While all home loans follow this basic structure, they can vary significantly and lead to a noticeable difference in the amount you pay in interest. Getting a home loan requires that you pay attention to and compare the following factors.
What is a home loan?
At its most basic, a home loan is simply a loan offered to a borrower for the purpose of buying a residential property, usually to be used as the borrower’s home or as an investment property. All leading banks and a number of credit unions across Australia offer home loans, although they have eligibility criteria in place for customers to ensure those who they lend money to are able to pay them back. For this reason lenders will take a look at your credit file, debts and assets carefully before approving any home loan.
But why would someone lend you money to buy a home? When a lender offers a home loan, they charge an interest rate. This rate may seem small, but over the usual lifetime of a mortgage (between 25 and 30 years) this interest nets them a profit. Your lender will use your home as security and you only completely own the home after you repay the loan in full. If you default on the loan, the lender holds the right to take possession of your home, sell it and use the proceeds to pay off your debt.
How much deposit do you need?
Most loans require a minimum deposit of 20% of the home's price in the form of a deposit, although this figure can go down to 5% if you opt for lenders mortgage insurance (LMI). LMI covers your lender in the event that you default on your home loan and they don’t make their money back by selling your home loan.
While most traditional loan terms vary between 25 and 30 years, you can also find alternatives that allow you to repay the loan in as little as 15 years or as long as 40 years. Changing your loan term can have a direct impact on the size of your repayments. Below are some of the most important aspects of a home loan.
The interest rate of a loan indicates the amount of interest you have to pay as part of your loan repayments. Rates can vary from one lender to the next, as well as between products from the same lender. Lenders calculate interest on home loans each month or on a daily basis. As you keep making payments towards the principal (the amount you owe), the interest you pay every month continues to reduce—as the principal reduces, so does the interest due. Monthly repayments remain the same because of a process called amortisation, where you start paying more towards the principal and less towards the interest.
Interest rates come in two types—fixed and variable—and each comes with its share of pros and cons. Repayments remain the same throughout the course of a fixed rate home loan, allowing borrowers to plan ahead suitably, although they don't benefit from drops in interest rates down the line. Variable rate loans, on the other hand, can benefit from drops in interest rates, but can also witness interest rate increases in unfavourable market conditions. Variable rate loans tend to offer increased repayment flexibility, lower fees and offset and redraw facilities.
Many lenders give you the option
to make repayments towards the principal and interest components of your home loan, as well as the option to make interest-only repayments. When making a principal and interest payment, your payment is divided into two sections—one goes towards the outstanding loan amount and the other towards its interest. During the course of any such loan, most of the initial repayments go towards the interest, but this then reverses towards the end of the term. For example, if you borrow $250,000 at 5.70% p.a. for 25 years, your first repayment would send $1,187.50 towards interest and only $377.72 towards the principal. By the 236th monthly payment, only $414.94 goes towards interest and you pay $1,150.28 towards the principal.
If you take out an interest-only loan your initial repayments go towards the interest, thereby making the payment considerably smaller. As the name suggests, these loans do not require you to pay anything towards the principal and as a result, you don't build any equity in the home for a while. Interest-only loans tend to suit investors as well as individuals who want to benefit from the initial phase of small repayments. Besides, these loans can also come with tax breaks and allow people to manage their cash flow more effectively. Once the interest-only period ends, borrowers need to account for the sudden rise in repayments as they move from interest-only to principal and interest.
Repayment options vary between loans. While some loans allow you to make weekly, fortnightly or monthly payments, this is not always the case. For example, a number of fixed rate and interest-only loans only allow monthly repayments.
If you have the option to choose between monthly and fortnightly payments, opting for the latter can save you money over the life of your loan. This is essentially because a year has 26 fortnights, which effectively allows you to make an extra monthly payment every year. For example, if you take out a 30-year $150,000 home loan at 6% p.a. and make fortnightly repayments instead of monthly, you could pay your loan off more than five years ahead of time and save more than $35,000 in interest.
Some loans allow you to make extra repayments in advance. While such loans tend to attract higher fees, opting to make extra repayments is a good way to pay your loan off sooner and save on interest. This holds true even if you increase your fortnightly or monthly repayments by as little as $20 or $50.
Some home loans come with a range of features that you may want to leverage during the life of your loan. Notable features include the offset account - a transaction-style account linked to your home loan - where the amount in the account offsets a portion of your principal, so your interest payments are smaller. Another is a redraw facility, which allows you withdraw any additional repayments you have made in case of an emergency. The portability function allows you to move your home loan with you if you ever move properties. Depending on your life stage, some of these features will be more useful to you than others.
How to apply for a home loan
If you're dealing with a lender for the first time, you’ll need to prove your identity with items such as your driver's licence, passport, birth certificate or medicare card. As part of the application process, expect lenders to delve into your capacity to make repayments on time. You also have to submit details surrounding all your assets and liabilities, your dependent children and your employment situation.
You’ll also need to submit documents to support what you claim in the application. These can include recent pay slips, group certificates and a letter from your employer detailing the length of your employment and your income. If you're self-employed you have to submit tax returns for the previous two years, financial statements for the last two years and contact details for your accountant.Source: www.finder.com.au