How do home loans work?
As you get ready to sign on the dotted line, it’s important to understand the financial commitment of owning a home, and what your options are when things change.
Choosing the term
The most common terms of a home loan are 20 and 30 years. The longer you have to pay it back, the lower the regular payment, but you will pay much more interest in the long run.
It can be advisable to select a longer term but pay as much as you can as you go along to pay down the debt as quickly as possible.
Paying off a mortgage early may incur a break fee – a one-off penalty payment for paying up early – but even if this is the case, it can be much less than the interest.
Floating interest rate
A floating rate means the interest is determined by the Official Cash Rate (OCR) set by the Reserve Bank. The Reserve Bank can raise or lower the OCR at any time. As the floating interest rate changes, your repayments change as well.
Fixed interest rate
‘Fixing’ your mortgage means agreeing to a set interest rate for a period, usually between six months and five years. The rate offered to you by the bank depends on the floating rates available at the time as well as the fixing period.
It provides a sense of certainty because repayments stay the same during the fixing period, but if the floating rate goes down, you can’t take advantage.
In the case of early repayments or changes, extra fees often apply.
Once the agreed period is up, you can either re-fix at the interest rates available at the time, or allow your mortgage to switch to floating rates.
Rather than committing to a fixed or floating interest rate, a split loan lets you spread the risk by placing part of the mortgage on a fixed rate and the other part on a floating rate.
This is a term that’s become well-known thanks to the pandemic. For an agreed period of time, the owner of a property only pays interest while the principal (the loan itself) isn’t paid down, reducing the regular payments.
In the case of a job loss or other change of circumstance, your bank might be willing to do so for a number of months to help you get on your feet. However, this is also useful for investment property, for owners who wish to maximise their tax deductions or get into property investing where they might not otherwise be able to cover repayments.
This type of home loan operates like a big overdraft, with no regular repayments. You can even access the money from your EFTPOS card. You can spend and repay as you like.
Lo Doc loans
Normally, lenders like to see a regular income before they offer a loan, but home ownership and property investment isn’t just for wage-earners. If your income is more sporadic, the bank may offer a Lo Doc loan which simply requires you to sign an agreement stating your minimum expected income.
The downside of this is the terms and interest rates are usually less favourable than a traditional home loan.
If you’re about to buy your next home and your current one hasn’t sold yet, you’ll need a bridging loan. As it’s designed to be temporary, when your former home does sell you’ll need to pay back the rest of the bridging loan.
Thinking of taking the plunge into home ownership? Read our tips for getting financially fit to buy.