With hundreds of mortgage products on offer, it’s not easy to pick the right loan. In fact, it can be downright baffling thanks to the sheer range of options and features that various products can offer – not to mention the interest rate. So where do you start?
“There are up to 26 different features or attributes that define the structure of a mortgage,” says Michael Lee, consumer advocate at KeyFacts. “That means there are up to 26 decisions that you will either make or have made that directly affect the financial cost of your mortgage, the safety it affords you and how much stress and time it takes to manage your loan.
“Although it’s tempting to focus on interest rates as a starting point for comparing your mortgage options, an interest rate quoted on a website, in a magazine, in a newspaper or over the phone could be the nominal rate, headline rate, start rate or comparison rate. Each one is different and each includes a different, incomplete set of fees that the lender will or is likely to add to your loan.”
Where to begin?
Before you get too confused by the range of options available, there are a few questions you should ask before you plump for a particular product. Key among these are:
- Principal and interest or interest-only?
- Flexible or basic?
- Fixed or variable?
Loan term is the number of years it takes to repay your mortgage assuming you only ever make the minimum monthly, fortnightly or weekly repayments.
“In recent years, as borrowers take on larger and larger loans, terms have stretched beyond the rather old-fashioned loan term of 20 years,” says Lee.
Although terms of 25 years were common a few years ago, 30 years seems to be the new 25 and some lenders are
even encouraging terms of 40 years.
The upside of taking a longer term is that your mortgage repayments will be lower compared with a shorter term loan. If your cash flow is tight, this will help you get over the financial difficulties. The downside of having a longer term mortgage is that you’ll end up paying more interest and will be in debt for longer.
“As a general guide, the decision to stretch your loan from 25 to 30 years reduces your repayments by just 6%, however it increases your interest cost by 25% (based on a 15-year average of competitive rates, which is around 7.09%),” says Lee.
“This means stretching your term from 25 years to 30 years for a $300,000 mortgage lowers your monthly repayment by just $124 a month, however it will cost you almost $84,000 in extra interest.”
Principal and interest or interest-only?
You also need to choose whether you want a traditional ‘principal and interest’ (P&I) loan or an ‘interest only’ (IO) loan. A P&I loan enables you to repay both principal (the actual money you borrow to purchase the property) and the interest on the outstanding debt over a specified period – usually 25 or 30 years. As more and more principal is repaid, interest repayments decline, and at the end of the loan’s term, the loan would be completely repaid.
With an IO loan, such as line of credit, however, the principal isn’t repaid at all during the interest-only term of the loan – it is repaid at the end of the loan.
IO loans are usually taken over five years, but the term can be anything from one to 10 years. After the IO period expires, the loan can be paid out, refinanced or you can revert to a P&I loan. IO loans can apply to fixed and variable home loans. Interest rates are usually the same as those offered on P&Iloans.
IO loans are typically preferred by investors, as less cash is used to repay the loan than would be required if paying off a P&I loan. As only interest is repaid on the loan monthly repayments are lower than those on P&I loans. This frees up cash for them to use elsewhere. IO loans are also popular as they allow investors to claim large tax deductions – they claim interest payments as an expense of their investment. Such deductions are larger than would be the case if the investor simply took a P&I loan.
The main risk of an IO loan is that a property might not increase enough in value to cover repaying the principal and interest costs due at the end of the loan. This is a real risk in a market where property prices aren’t growing significantly, as is the trend at the moment.
“What many people overlook is that you have a larger debt for longer, which means you will pay more interest. What’s more, if your loan switches to a P&I after a certain period, say, five years, then your P&I payment will also be higher than if you took P&I from the very beginning, because you have a shorter time to repay your debt,” warns Lee.
Lenders are also reluctant to lend firsttime buyers interest-only loans at present, especially if they’re taking out a high loan-to-value ratio mortgage. You may find that a lender insists upon a P&I loan at least to begin with, until you’ve built up some equity in the property and the LVR is lower.
It all depends on your initial aims. If this is to build your wealth, then your best option is to repay principal and interest. A P&I loan allows you to reduce your debt to the bank and build equity in your home – in other words, it allows you to build up your wealth.
By paying principal and interest as opposed to just paying interest only, you will end up paying a lot less interest and you can build up your home equity a lot quicker. The downside is that your mortgage repayments will be higher.
Using the same rate (15-year average rate of 7.09%) as above, Lee explains that the decision to take an IO type on an ‘evergreen’ facility such as line of credit reduces minimum monthly repayments by around 14%, however it increases your overall interest bill by 50%.
“This means taking an evergreen interest only facility for 30 years – but keep in mind many lenders will only go to 25 years for this type of loan – on a $300,000 mortgage lowers your monthly repayment by around $242 a month; however it will cost you almost $213,000 in extra interest. Of course, shorter IO terms will reduce the cost, however the underlying problem of paying more for interest for small reductions in monthly repayments still applies,” he says.
Flexible or basic loan
The next important step is to decide whether you want a mortgage with fancy features, or whether you want a basic loan at the cheapest price.
A flexible loan – this includes most standard variable loans – typically offers features such as allowing you to repay your loan early without penalty or repay extra when you feel like it with the ability to access it a later time. These features allow you to dramatically cut your interest costs over time. Flexible loans, which are priced above basic variable loans, can also offer valuable features such as offset or all-inone facilities.
An offset or all-in-one facility allows you to have a savings account, the balance of which directly offsets your mortgage principal. This enables borrowers to cut interest costs substantially if they have a sizeable savings balance.
Flexible or standard variable loans also usually allow borrowers to redraw surplus repayments without penalty or for a small fee. Many basic loans don’t allow redraws, or lenders might impose very high minimum redraw amounts or limit the number of redraws you can make.
Some flexible loans also include a line of credit (LOC) facility. Essentially, this allows you to access additional funds by drawing on the equity value of your home – effectively turning your mortgage into a very, very large credit card.
Basic variable loans often don’t allow borrowers to make extra repayments or repay the principal early without penalty and they don’t carry offset facilities.
The upside of basic variable loans is that they tend to be a lot cheaper (lower interest rates) compared with the featureheavy standard variable loans. Many lenders have also started adding flexible features such as redraw in their basic loan offerings. So if you’re unlikely to have a substantial amount of spare cash that you can park in your offset account, then a basic variable loan might be more suitable for you.
Fixed or variable loan
A fixed-rate loan is best for people who like the security of knowing their repayments. A variable loan is best for those who like to keep their interest costs to the very minimum, and who are happy to gamble on the future direction of interest rates.
With a fixed rate loan, your interest rate and repayments are fixed for a set period, usually between one and five years. Most loans default to a variable loan at the end of the fixed term, or you can usually roll over to another fixed term. Fixed rates are usually priced above variable rates as fixed rates include a premium to allow for inflation.
A variable loan, meanwhile, can see the rate move from month to month.This is mostly influenced by changes in the cash interest rate, as set by the Reserve Bank of Australia on a monthly basis; however, it can also be impacted by commercial situations. For example, when the Reserve Bank raised the cash rate by 0.25% in November last year, the four major lenders all increased their standard variable rates by between 0.35% and 0.45% to cover increased funding costs. However, when interest rates fall, borrowers also see their repayments decrease – such as in 2008–09 when interest rates were at a historically low level of 3%.
The main advantage of fixed rate loans is that if interest rates rise, then you could save substantially on interest costs. It is also easier to budget for the middle to longer-term as you know what you are up for. Many analysts predict interest rates will rise by 2% over the next year or two, driven by the resources boom, low unemployment and the strong economy. The main disadvantage with a fixed rate, however, is that if rates fall, you are stuck with a higher rate – and you could end up paying more in interest costs compared with a basic or standard variable loan.
Fixed rate loans can also have substantial exit fees or break costs which are levied if borrowers repay their loan early. Some fixed rate loans also restrict borrowers from making extra repayments or redrawing, or they don’t allow fortnightly or weekly repayments. It is essential to check whether any of these limitations apply prior to going for a fixed rate. It’s important to shop around, as some fixed loans are more flexible than others.
The vast majority of Australian borrowers prefer to take their chances with variable rate loans, due to their added flexibility and features available. However, fixed-rate mortgages have seen a surge in popularity over recent months, as the spectre of significant rate rises over the coming years – up to 2% according to some commentators – makes locking your rate in more attractive.
The example opposite suggests how the rate on a variable and a fixed-rate mortgage for $400,000 might compare with a rising interest rate environment for the next year.
As you can see from this rough example – which assumes a high interest rate environment – the variable rate comes out slightly ahead. If interest rates do not rise this much, then the variable will be cheaper. Likewise, if interest rates rise further, the fixed rate looks like a good deal.
Much like the first two questions, which option you go for will depend on your personal circumstances, whether you’re happy to ride the ups and downs of the interest rates, how much month-tomonth security you need and what your future plans are.
Making a decision
The range of mortgage offerings continues to evolve and, while the information you’ve learned in the past may still be useful, it could now be outdated.
Therefore it’s important that you do your own research and talk to relevant advisors. Your first port of call to compare the interest rates, fees and features on fixed rate and variable home loans is likely to be comparison sites such as the Your Mortgage website, www.yourmortgage.com.au, which provides up-to-date mortgage rates and lists the cheapest loans currently available in Australia.
You can also engage a mortgage broker to help you sift through the pile of home loans available. Brokers can serve as a great resource to borrowers as they will typically have the latest information about home loan products.
The best way to find a top-notch broker is by word of mouth. Ask friends and family if they have used a good broker or know of one. If you get a name, pick up the phone and talk to the broker. If the on-phone conversation goes well, arrange to meet. If word of mouth recommendations don’t pan out, then choose a broker who works for a large, recognised firm.
Once you find a broker, use the broker checklist on page 42 to check their credentials. As a basic rule of thumb, make sure any broker you consult represents at least 15 home lenders. Check if your broker is a member of a professional association. Make sure you ask about commissions brokers get paid from the lenders they recommend. Once you have the advice of a broker, you don’t have to accept it. Their advice is free, or at least it should be. If you find a broker who charges upfront fees, look for another one as most brokers don’t charge for their services.
If you choose to undertake the home loan search alone, prepare for some hard work. Create a list of questions to put to all your prospective lenders. Your basic questions should at least cover interest rates, loan features and fees. Some of the answers will be confusing, even apparently contradictory and, once you’ve visited four or five lenders, it may all become an impenetrable maze of information unless you keep detailed notes.
The sheer array of lenders can be a challenge, too. Most borrowers head straight to the ‘Big Four’ banks – Commonwealth Bank, Westpac, NAB and ANZ – but there are a plethora of smaller lenders out there as well, including smaller, local and international banks (although some of these have been acquired by the Big Four during the GFC – notably St.George and Bankwest), credit unions, building societies and specialist ‘non-bank’ lenders – including some ‘web-only’ lenders.
The advantage of banks is that they typically offer customers completely integrated financial products. Banks can provide customers with savings accounts, credit cards, home insurance and other financial services for free or at a discounted cost, which many nonbank lenders don’t offer. However, nonbank and smaller lenders should not be discounted altogether, as they can offer competitive interest rates, innovative features and often cater well for situations which mainstream lenders may shy away from – self-employed borrowers, for example.
Don’t be afraid to try and negotiate either. Lenders may be willing to include extra features on basic loans – ideally one provided by a rival lender – waive fees or even offer discounted rates, especially if you’re looking at taking out a significant mortgage and/or other financial product. While the mortgage market may not be as competitive as it was before the GFC, there’s still plenty of competition out there for new business: if you don’t ask, you don’t get.
Knowledge is power
The better informed you are, the more likely you will be to choose a home loan that genuinely meets your needs.
If you are a first-time borrower, then you’ll probably want a loan that allows you to repay your loan off as quickly as possible to keep interest costs to a minimum. You may also have half an eye to the future, and may be considering investing in property or upgrading a few years down the track. Several loan types from different lenders allow you to do just that, while retaining flexibility for the future.
The most important point for a first timer is to identify what you actually want out of your home loan. Identify your goals and stick to them; do your research about the different types of home loans and make sure you ask lots of questions.