Since the Reserve Bank of Australia started its upswing in the official cash rates in May 2022, there was a great deal of attention paid to the variable rates of lenders. Now more than ever, the interest rate has become one of the most important factors in a home loan.
However, flexibility remains a top consideration, as many borrowers try to look for ways to ease the impacts of the rising rates on their home loans.
Nearly all variable home loans have some repayment flexibility. At a minimum, they give you the ability to make extra repayments when you can. 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.
Loan features that offer flexibility
Home loans come with features that help you pay off your loan faster or reduce the amount of interest charged.
Offset accounts
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, or the most popular name: 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.
Most people take advantage of this feature by setting up their salary to be directly deposited to their offset accounts. This reduces the outstanding balance which interest is calculated 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 Interest is calculated daily, so even if some of your pay is withdrawn after one day it has contributed to reducing the amount of interest you are charged.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 can keep the money in the home loan account, the less interest you will be charged.
The ways in which you can access the money you have paid into your home loan accounts vary 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 were 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.
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 essential 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.
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.
The fee per redraw is the charge per withdrawal after you have used your quota of free redraws. For example, if you are allowed two 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 that reduces the flexibility of many redraw facilities and can limit them from 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.
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.
However, 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, the most restrictive factor is the minimum amount that can be redrawn. If you place 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.
How much flexibility do you really need?
As the interest rate rises so does the flexibility of the loan. You can pay for a slightly higher interest rate for the features that can help you save on interest and pay off your loan faster or you can choose the basic, no-frills option if you want to keep things simple.
However, to be better off with the more flexible loan you must 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 that is paid towards the loan per period.
The more you pay, the faster you will pay off the loan and the less interest will be charged.
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 only a psychological effect or the offset effect.
In fact, the same amount could be paid on a basic variable loan, although you would have to make the additional payment yourself.
This is rather difficult to do, especially when 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.
At the end of the day, you will need to assess yourself whether paying a slightly higher interest is going to be beneficial — are you going to religiously keep your offset account or redraw facilities funded to take advantage of their full benefits?
Furthermore, the choice will depend on your current financial health. If you are unsure, consult a registered mortgage broker to know your options.
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