How much flexibility do you really need? When should you consider a low rate in favour of a flexible loan and vice versa? Your Mortgage magazine investigates.
Since the Reserve Bank of Australia started slashing the official cash rates aggressively in September last year, there was a great deal of attention paid to who had the cheapest variable rate. The interest rate has become the most important factor in a home loan. It is generally believed that if you have a low rate you are on the right track.
Nearly all variable home loans have some repayment flexibility. At a minimum, they give you the ability to make extra repayments when you are able to. Choosing a home loan can, in a sense, be viewed as a trade-off between the interest rate and repayment flexibility. You can choose a low rate with limited flexibility, or a relatively high interest rate with a lot of repayment flexibility. This flexibility provides the opportunity to reduce the total cost of the loan.
The question many borrowers face is whether they should pay a higher rate to get the additional features, or whether they need a low interest rate.
To a large extent, the answer lies in the borrower’s financial situation and to what extent they will be able to exploit the greater flexibility. To put it simply, it is not worth paying extra for something you are not going to get a great deal of use from.
Home loans which allow you to pay your income into your home loan account and withdraw it as required come under a variety of names – all-in-one accounts, revolving lines of credit, home loans with a salary account and 100% offset accounts.
Technically, with a 100% offset account, you do not put your money into the home loan account; instead, you place it in a linked account. The balance in the 100% offset account is deducted from the balance in the home loan account to determine the amount on which interest is charged.
The difference between having one account or two lies in the details, the interest calculated will be the same. For simplicity’s sake the term ‘all-in-one’ home loan will be used.
All-in-one home loans allow the borrower to deposit all their income into their home loan account with the knowledge they can access it when required.
As most people’s main source of income is their salary, it is directly credited to their home loan. This reduces the outstanding balance which interest is calculated on as soon as you are paid. Interest is calculated daily, so even if some of your pay is withdrawn after one day it has contributed to reducing the amount of interest you are charged. The longer you are able to keep the money in the home loan account the less interest you will be charged.
One of the most effective ways to take advantage of this is to use a credit card with interest free days (see the box below for more details).
Combining with a credit card
A large number of institutions offer credit cards with up to 55 interest-free days. This basically equates to 25 interest-free days from the date on your credit card statement. If you make a purchase the day after your statement, you receive the maximum interest-free days. If you make a purchase the day before your statement you get approximately 26 interest-free days.
If you make as many of your purchases on your credit card as possible and pay off the total balance the day before interest is to begin being charged, you can leave as much money in your home loan account as possible – reducing the balance and the interest charged.
It is possible to extend the number of interest-free days by having multiple credit cards with staggered statement dates. When one credit card nears its statement date you switch to another with a later statement date – extending the amount of time before you have to withdraw money from your home loan account to pay off the credit card balance. However, this strategy only works if you have financial discipline and are able to track your expenses so as to keep your spending under control.
Access to your all-in-one account
The ways in which you can access the money you have paid into your home loan accounts varies from loan to loan.
The number of ways you can access accounts in general continues to increase with internet access being added to withdrawing or transferring funds over the counter, via ATMs, cheque books, EFTPOS, over the phone and at agencies such as post offices.
Giving the borrower easy access to their funds when required has been an advantage banks, building societies and credit unions have had over other home loan lenders because offering transaction accounts to customers was already part of their core business. This has changed, with mortgage managers negotiating the ability to provide these facilities on their loans through other institutions, primarily the banks.
The line of credit facility
A line of credit allows you to access the equity you have built up in your home to borrow for other purposes at home loan rates
when you need to.
Your equity in your home is the difference between its value and the amount you owe on it. For example, if your home is worth $500,000 and you owe a total of $300,000, your available equity is $200,000.
A line of credit, secured by your home, allows you to have access to this equity, as you require it. For example, when an investment opportunity arises or when you want to buy a new car. Some products are also promoted as providing the opportunity to reduce the interest expense and term of your loan using its repayment flexibility.
It is important to recognise that the flexibility of either loan allows it to be used with different goals in mind - to repay your loan as quickly as possible, to consolidate all your debts or with some lines of credit, manage the cash flow of your business.
The main differences between products lie in the interest rate, the access to the account and the associated costs, plus the amount of credit to which you have access.
While lines of credit can be an effective means of consolidating your debt at a relatively low interest rate, they can also lead to you making little progress towards owning your home if you do not use them in a disciplined manner. Every time you access your line of credit, you reduce your equity in your property.
Differences in access
Assuming you intend to pay off your home loan as fast as possible and pay as little interest as possible and you are faced with a choice of a wide variety of home loans.
It is not possible to say which loan will best allow you to do this without taking into account your personal financial situation and how you will be able to take advantage of different products.
In nearly all cases, it is possible to make additional repayments on variable rate loans without penalty. Some lenders charge a fee, often called a deferred establishment fee, if you pay the loan out in full within a certain period of time. The ability to re-access additional repayments at a later date varies significantly.
The access to additional repayments made on variable loans can roughly be divided into three groups.
- no access to additional repayments
- a redraw facility
- flexible access to additional repayments
- No access
No access means it is not possible to access additional repayments which have been made under the terms and conditions of the loan. Any amounts above the set repayments once paid towards the loan cannot be withdrawn. For example, if you have an offset facility and you pay extra into your mortgage, you won’t be able to access this extra money paid unless you have a redraw facility. The offset facility allows you to put money in and take it out, and it is linked to the mortgage. However, unless your mortgage has a redraw facility, you cannot access any additional repayments you make into your loan. The majority of loans described as basic variable loans do not have a redraw facility.
- Redraw facility
A redraw facility is a feature that allows the borrower to withdraw additional repayments which have been made, subject to certain terms and conditions.
The terms and conditions vary significantly between loans.
Conditions for comparing redraw facilities are:
- the number of free redraws per year
- the fee per redraw
- the maximum number of redraws per year
- the minimum redraw amount
- the maximum redraw amount
The number of free redraws per year, as suggested, is the number of times per year you can withdraw additional home loan repayments you have made at no charge.
This varies significantly between lenders from none to no limit. For example Mortgage House, Resi Mortgage Corporation and the Commonwealth Bank of Australia allow unlimited free redraws on their standard variable loans.
The fee per redraw is the charge per withdrawal after you have used your quota of free redraws. For example if you are allowed 2 free redraws per year and the fee per redraw is $20 you will be charged $20 for your third redraw of the year and any thereafter. The fee per redraw can be as much as $50.
The minimum redraw amount is the smallest amount you can withdraw. This is an important factor to consider as it determines how flexible the redraw facility is. The minimum amount per redraw is generally between $500 and $5,000. This is the main factor which reduces the flexibility of many redraw facilities and can limit them being used on a regular basis and where they differ from all-in-one accounts and 100% offset accounts.
The maximum redraw amount is usually the total of additional payments which have been made. Some lenders set the maximum at the total of additional repayments less one month’s payment (see Table 1 below).
A redraw facility can be a valuable feature because it can allow you to make additional repayments – which can significantly reduce the total amount of interest you repay on the loan – with the knowledge that you can access the money at a later date. It can be seen from Table 1, however, that a simple redraw facility is not flexible enough to allow you to use your home loan as your main financial tool by putting all your income into it and withdrawing amounts as required.
In some cases the factor restricting frequent use is the fee per redraw, in others the number of redraws you can make each year. Generally though the most restrictive factor is the minimum amount that can be redrawn. If you place pay all your income into your loan account as an additional payment you could find yourself in the ludicrous situation of having to withdraw $2,000 to go to the corner shop for a newspaper or a coffee.
There is some potential to use a redraw facility in association with a credit card, which you pay off once a month (as described previously).
If you put the majority of your pay into your home loan (keeping an amount to cover necessary cash expenses) and make as many transactions as possible on your credit card, you can make one redraw a month to pay off your credit card.
But this is not the intended purpose of redraw facilities, and it is quite possible you will end up in a financial squeeze at one time or another trying to use them in a way they are not designed for. As previously stated, redraw facilities are more a form of security which allow you to make additional lump-sum repayments when you come into extra money. You make these extra payments with the knowledge that you can get them back at a later date.
Table 1: Examples of redraw facility conditions
||Number of free withdrawals per year
||Fee per redraw
||Maximum number of redraws per year
||Minimum redraw amount
||Maximum redraw amount
||Freedom Home Loan
||Standard Variable Home Loan
||Complete Home Loan
||Standard Variable Home Loan
||Base Variable <250K
*excess means the total of additional payments which have been made
- Flexible access
The ability to pay all your income into your home loan, or a linked account, and access it as required is being offered by more lenders.
Three important factors to consider in relation to the access you have to your funds are:
- the different ways you can access your funds
- the number of free transactions per month
- the cost per transaction after the free transaction limit has been exceeded.
There are a wide variety of means by which you can access accounts these days. It is possible to move your money around over the telephone or using the internet. It is possible to withdraw money at a range of retail stores using EFTPOS, and post offices act as agencies for several financial institutions.
When looking to use your home loan as your main financial account, it is important to consider your needs. The main thing you are trying to do is to leave as much of your money in your loan account for as long as possible.
If an account only allowed you to make branch withdrawals, leaving as much of your income in the account for as long as possible could mean spending most of your lunch break each day in a queue at the bank, taking out the money for that day and the following morning. Alternatively, if you withdraw an amount once a week when you get paid to cover the week’s expenses (to avoid wasting your lunch hour) you have gained no or little benefit from having this type of account.
All-in-one accounts can allow you to use your home loan as your main financial product. In fact this is the way you will get the most benefit from it. There is no point having another savings account or transaction account with money in it unless it is earning a higher interest rate than the rate you are paying on your home loan. You also need to consider the tax you will pay on the interest you earn with the savings or transaction account. Funds offsetting your loan balance do not incur taxable interest despite earning an effective interest rate equal to the home loan interest rate.
To use your all-in-one account as your main financial tool it has to meet your needs. For example, if you write a lot of cheques it has to have a chequebook facility.
The cost of making frequent transactions to leave as much money in your account also needs to be considered. The fees charged on transaction accounts are a common gripe, and for many people they can surpass the interest you earn.
Most all-in-one home loan accounts, or home loans with a 100% offset account, allow a number of free transactions each month following which you are charged for each transaction. Many institutions charge different amounts for different types of transaction (see Table 2 below).
As can be seen, all the loans offer at least some free transactions per month. However, it is important to keep the monthly ongoing fee in mind.
It is important to consider how many free transactions you actually require. As we stated before, one of the most effective ways of using these types of loans is in conjunction with a credit card with interest-free days, paying off the credit card at the end of the interest-free period. If you were able to put all of your expenses on your credit card you would only need one free transaction per month to transfer money from your home loan to your credit card account.
Table 2: Examples of free transactions
||Line of Credit
||Portfolio Variable Loan
||PAP Equity Access $250-500K
||Line of Credit Loan
Note, many institutions have ATM’s they prefer you use which are usually their own plus those of affiliated institutions. The fee listed is to use a preferred ATM. The fee may be higher if you use a non-preferred ATM. Also, in many cases all transactions from non-preferred ATMs incur a charge whether you have exceeded your limit or not.
Source: Your Mortgage database, correct as at 26 May 2009
How much flexibility do you really need?
Generally speaking, as the interest rate rises so does the flexibility of the loan. To put things into perspective, say you are paying a rate 1.5% lower for a basic no frills loans compared to a feature-laden standard variable loan.
On a $100,000 loan over a period of 25 years, where only the regular repayment is made each month, this equates to approximately $640 a month versus $730 a month, or in terms of total interest over the term of the loan approximately $91,000 versus $120,000.
To be better off with the more flexible loan you have to be able to make significant savings due to the greater flexibility.
The main factor this will depend on is the amount of income you are able to leave in the home loan account and for how long. The point that makes evaluating the difference between flexible and more traditional loans very difficult is the amount which is paid towards the loan per period.
As long as you are able to make additional payments at no cost, regardless of the loan, the more you pay the faster you will pay off the loan and the less interest you will pay.
Having your salary paid directly into your loan account or a 100% offset account may lead to you paying more towards your home loan. This may be because you do not like to withdraw money from your loan account – but this is really only a psychological effect. The same amount could be paid on a basic variable loan, although you would have to make the additional payment yourself.
The effect which needs to be measured to compare the loans which allow you to offset all your income against the loan balance against those which do not is the reduction in the interest charged due to the offset effect.
This is rather difficult to do, especially when you are taking advantage of a credit card with interest-free days. It is necessary to be able to reduce your loan balance for a period of time such that the amount on which interest is calculated makes the amount of interest calculated less than if you had taken out a loan without this facility.
A basic example over two months can give some indication of how much you need to reduce the balance by.
The comparison is between an all-in-one loan with an interest rate of 7% and one without this facility and an interest rate of 6%.
- Net income is $500 a week, first pay day will be day one of the loan.
- Months have 28 days.
- The daily interest rate on the variable loan at 6% is 0.0179% (12 x 28 = 336; 0.06/336 =0.000179), the daily interest on the all-in-one loan is set at 0.0208% (0.07/336 =0.000208).
- Interest is calculated on the daily balance of the loan account and charged at the end of the month.
- As stated previously, for the comparison between the two types of loan to be fair, the amount paid toward the loan should be equal. While this is a reasonable concept exactly how it is treated is a little more complicated. It will be assumed that on both loans you pay the monthly repayment on the 6% loan which is approximately $650 per month.
- All expenses are put on a credit card and repaid on the last day before interest is accrued. This means expenses over the month are $2,000 less $650, or $1350.
Once you have done this, if you decide it is worth paying a higher rate to have your income offset your home loan balance you need to choose which loan best suits your needs.
It can be confusing to know whether to get a variable rate or fixed rate mortgage, and what features are important. That's why it's important to not only check the right rates, but make sure that you're getting the right features in your home loan. Get help choosing the right home loan