Variable Rate - What loan is that?

By Nila Sweeney

Variable rate

“Variable rate loans can be more flexible and typically offer more features than fixed loans. They’re suitable for borrowers who don’t need absolute certainty over their repayment amount, due to fluctuations in interest rates. Consider the general trend of future rate movements – keep an eye on the Reserve Bank of Australia’s official cash rate, which has a strong influence over home loan interest rate movements”
Kristy Sheppard, senior corporate affairs manager, Mortgage Choice Limited

Key features
Variable rate loans have traditionally had interest rates which, over the life of the loan, track the interest rate movements set by the Reserve Bank of Australia (RB A).

Due to the increased costs of funding caused by the US sub-prime crisis, many bank and non-bank lenders across Australia have raised rates independently of the RB A.

In addition, when the RB A cut rates, some lenders fail to pass on the full amount.

There are two types of variable rate loan. These are standard variable and basic variable.

Standard variable rate loans carry flexible features such as offset, redraw, extra repayments and the ability to split the loan.

Basic variable loans carry cheaper rates but often lack flexible facilities.

If the RB A cuts interest rates, your repayments will probably also drop. Variable rate loans are generally cheaper than fixed rates. The flexibility in repayment without penalty is handy if you want to pay off your mortgage quicker and reap substantial savings
in interest.

If interest rates go up, the extra rate rise is charged on a monthly basis and added to the loan, making repayments higher. However, some variable rate loans can be capped.

Suitable for
All types of borrowers who can
allow for a marginal rate increase,
but want to benefit if rates decrease. First homebuyers should ensure they could service their loan should rates increase.

Introductory rate
“On the surface these products look appealing. Borrowers should exercise caution and consider the full details of the loan – for example, the comparison rate of the relevant loan product, the revert rate after
the expiry of the introductory rate and the capacity of the borrower to meet repayments once the revert rate kicks in”
Ken Sayer, MD/CEO, Mortgage House of Australia

Key features
Also known as ‘honeymoon rates’, these loans usually offer the lowest interest rates available in the market. Interest rates are discounted for a certain period of time, which can vary for the initial months of the loan, depending on the institution and the product structure. After this ‘honeymoon’ period, the interest rate reverts to the standard variable rate, which is higher.

The main benefit is that you have a softer introduction to having a mortgage because you’re paying lower instalments during the intro period. This can help you get ahead financially during those first few months.

When the ‘honeymoon’ period ends, the interest rate is likely to be higher.

It’s important to find out what the revert rate is to ensure you won’t be paying a higher rate than the standard variable rate in the market, thus cancelling out any savings. Also check to see if the loan rolls over to a fixed or variable rate product.
Ask your lender about the costs of discharging the loan or switching, and whether you’re able to make extra repayments during the introductory period. You need to assess what the benefits are going to be over the long term rather than the short term.

Suitable for First homebuyers who are breaking into the mortgage market would benefit from the lower intro rates while they get used to paying their mortgage. Intro loans are also worth considering if you’re refinancing and need a short-term financial boost.

“Although rates are the same, these loans cost more, as they require multiple inspections as construction progresses. The fees for these visits and the number of visits vary between lenders, but the overall cost shouldn’t exceed $500”
Michael Lee, spokesperson, Mortgage KeyFacts

Key features
Designed for borrowers building a new home or planning major renovations to their existing dwelling, these loans carry variable rates and feature an interest-only repayment structure during the construction phase. After the project is completed, the loan reverts to principal & interest (P&I). Unlike standard home loans, the funds are drawn down in stages rather than as a lump sum payment.

You only have to pay interest on the money you’ve drawn out rather than on the total mortgage amount. You’re also allowed to make unlimited repayments during this period.

Because construction loans are variable rate loans, if rates go up during construction, your repayments also rise. These loans don’t allow you to convert to fixed term during this phase. Since you’re only paying interest on the amount you’ve drawn out, you’re not significantly reducing your total debt.

Suitable for
As the name implies, construction loans are suitable for those undertaking major capital works on their property.

Low- and no-deposiosiosit
“Borrowers must be aware that these types of loans mean that they’re virtually borrowing 100% of the value of a home. Borrowers have little or no equity and, unless they have good cash flow (income), they shouldn’t take up this type of facility. And, if they do, they must ensure they build up equity (by paying more each month) for that rainy day. Suitable for first home buyers, in permanent employment and with a sound income”
Iain Forbes, director of sales and marketing, and founding director, Australian First Mortgage

Key features
ow-deposit loans require a minimum deposit of 3–5% of the purchase price plus costs. Many lenders accept non-genuine savings, which means you can use gifts in lieu of personal savings. Because you have some equity, the lenders mortgage insurance (LMI) fee
is also reduced.

No-deposit loans, which come in the form of 100%, don’t require genuine savings, and you can use government grants and gifts to offset the costs incurred. With a 100% loan, you’re borrowing the entire value of the property but still have to pay for the costs involved in buying a home. Typically, LMI can’t be capitalised on 100% loans

hese types of loans enable you to get into the property market sooner. By borrowing the entire value of the property through a 100% loan, you only have to save for the costs associated with buying.

The less money you put in upfront, the more you borrow – and the more interest you pay in the long run. Generally, interest rates on higher lend products are above the standard variable rate. You’ll be required to take out LMI to compensate for the added risk in taking out a loan to 100% of the property value. Generally, this is 2.5% of the loan amount.

Suitable for
Those capable of meeting their home loan repayments but who have a small deposit.

“Low-doc loans usually carry a higher risk to the lender as the borrower hasn’t demonstrated, through financial statements, their ability to repay the loan, and therefore incur a lenders mortgage insurance fee when borrowing more than 60% of the value of the property. They’re also capped at 80% of the property valuation”
Sarah Eifermann, mortgage planner, SFE Loans

Key features
Aimed at self-employed borrowers, a low-doc home loan is exactly that – it requires far less documentation to prove your income, savings history and capacity to repay the loan. No-doc loans operate in much the same way, but have now been taken off the market as a result of the sub-prime crisis.
Low-doc applicants must show evidence of either business or personal income through bank statements ortax returns.

Low-doc loans allow creditworthy borrowers who are unable to provide full financial documentation to obtain a home loan. They’re extremely handy for self-employed people who, for whatever reason, would prefer not to disclose the source of their income. Borrowers aren’t required to disclose their income or assets and liabilities.

Low-doc loans may attract higher interest rates, depending on the level of risk perceived by your lender. You may also have to pay extra fees and charges, including ‘risk fees’. Low-doc loans of most mainstream lenders also require a clean credit history.

Suitable for
These loans are suitable for those who struggle to verify their income to lenders, including the self-employed – particularly those experiencing timing delays in preparing their tax returns. They’re also designed for contract and seasonal workers, or families who have just moved to Australia.

“Credit-impaired or non-conforming loans are for people who don’t meet mainstream lenders’ strict lending criteria, including people with a bad credit history, a history of late repayments or loan defaults, or who were possibly even formerly bankrupt. Rates for these loans are much higher then traditional ‘conforming’ loans”
Sebastian Farini, general manager, Austral Credit Union

Key features
Home loans for the credit-impaired
are in most cases no different
from mainstream loans in the variety
of choices that are available, such
as variable rate, fixed rate or line of credit (LOLOC). They also offer similar functions such as redraw and offset facilities. They’re targeted at borrowers who have had credit problems in
the past and may have difficulty qualifying for a regular home loan.

Borrowers who have been rejected by a mainstream lender due to their poor credit history, such as bankruptcy or defaults, are now able to obtain a mortgage to fund their home purchase or property investments.

Interest rates tend to be higher due to the risk factors taken into consideration. Lenders call this the ‘rate for risk’ model, which means that the higher the perceived risk that you may default on your repayment, the higher the interest rate you’re charged.

Suitable for
If you have a less-than-perfect credit history and are having some financial difficulties, these loans may be a
viable option.

Fixed rate
“The ideal loan option if seeking security in an increasing interest rate climate because the rate doesn’t change during the fixed term selected (normally one to five years). For borrowers with several loans/properties, such as investors, an increase in interest rates across all loans may impact cash flow, so having one or more loans fixed provides peace of mind”
Martin Castilla, personal mortgage advisor and franchisee with Smartline and guest lecturer in property financing at TafeSASA and The Property School (NSNSW)

Key features
Fixed rate loans are priced according to a pre-determined interest rate, which is independent of fluctuations in the official cash rate. You can fix your entire loan for a period of between one and five years, or you can fix a certain portion and leave the rest variable. When the fixed term expires, the fixed portion generally reverts to the prevailing variable interest rate.

If you’re worried that interest rates may rise in the next few years, locking in an interest rate by fixing a portion of your loan is an insurance policy against rising repayments. At present, fixed rates are almost on par with variable rates. Although there’s normally a fee charged for fixing a loan, the added certainty fixing brings makes these loans attractive.

Besides a fee for setting up the fixed and variable portions should you choose a split loan, you’re charged if you leave the fixed term before it expires. Fixed rates have been criticised for their lack of flexibility. They can lack features and charge fees for transactions such as redraw and lump sum repayments. This is changing, but check with prospective lenders to make sure the fixed product contains the features you require. While you’re insulated from rate rises, you won’t benefit if rates drop during the term.

Suitable for
Anyone who’s concerned that interest rates may rise in the near future, or who needs to know exactly what their repayments are.

Line of credit
“This is more of a mortgage facility, rather than a distinct product. In fact, anyone who has redraw is exercising their ‘line of credit’. This product’s origins were in business lending, however, it has naturally migrated to household mortgages. A great facility to have, especially for people who want to repay their mortgage early”
John Mohnacheff, managing director, BEATAT Home Loans

Key features
A line of credit (LOLOC) allows you to access additional funds by drawing on the equity value of your home. Setting up an LOLOC involves fixing a limit on how much you can borrow – generally, it’s a fixed percentage of your loan amount. You direct income from all sources into the LOLOC loan account and then draw down funds as and when required.

You have greater flexibility in managing the size and the timing of your repayments, enabling access to additional funds and even taking your mortgage with you to a new house. Because your entire income stays in your account until you need it, a major portion of it stays in your loan account longer and saves you interest. LOLOCs are a great way to fund projects when you need access to your funds in stages over time – such as for a home renovation.

These products may seem like the best thing since sliced bread, but be warned – most come at a price, and could be a loan feature that may not actually pay off financially. If you’re not disciplined with money, you’re probably best not to draw down on your home equity.

Suitable for
A LOLOC is a sensible choice only if you’re extremely disciplined in managing your everyday finances. If you’re likely to be tempted to use the funds for spur-of-the-moment purchases, an LOLOC is probably not for you.

Equity release

“Equity release products are also known as reverse
mortgages. These products suit retirees and elderly people who have a large amount of equity in their
home but are cash-poor. The aim and benefit of
an equity release product is that senior citizens with real estate assets can access money to support their
lifestyle in retirement. It’s important for consumers to consider their pension, superannuation and taxation
implications before entering into this type of product”
Phillip Minett, mortgage manager,
Wizard Sydney

Key features
An equity release mortgage allows you to borrow an amount equivalent to the equity or cash in your home while you still live there. The most popular type of equity release is the reverse mortgage. Repayments don’t have to be made until you die or move into
long-term care. Then the loan must be paid out in full, usually out of the proceeds of the sale of the property.
If you’re 60 years or older and own your home, you can borrow 15–45% of the value of your property.

You have access to funds while still living in your own home and retaining ownership. You’re not solely reliant on a pension or superannuation policy.

Reverse mortgages are generally more expensive than traditional loans and can be restrictive. If you’re not
making regular repayments each month, you’re not reducing your debt but accumulating interest. To
protect yourself, you need to get a ‘no negative equity guarantee’ from your lender. Members of the Senior
Australians Equity Release Association of Lenders (SEQUAL) are required to offer this assurance. It’s vital to get independent legal advice before taking up this type of mortgage, and to check with Centrelink in case it affects your pension. You may also want to discuss this option with your family.

Suitable for
Retirees who own their home but don’t have enough cash for living expenses, and Baby Boomers seeking
to retire in the next five years. It’s also worth considering if you decide to look at reverse mortgages as a form of superannuation or paying for retirement.

Shared equity mortgage
“As there are no ongoing monthly interest and/ or principal repayments, a borrower has the choice of
increasing their borrowing power or reducing their repayment levels. As the lender receives their payment through a share of the capital gain when the property is sold or refinanced, their interests are aligned to the borrower. Only if one does well will the other do well”
Tim Piper, chief general manager,
wholesale mortgages, Adelaide Bank

Key features
In a shared equity scenario, there’s a mixture of debt and equity. A lender provides debt for the mortgage in partnership with an equity provider, which is effectively taking a stake in the house, rather than providing money to a borrower which becomes the borrower’s 100% debt.

A shared equity mortgage enables the borrower to buy a more expensive property as they’re not required to make principal & interest (P&I) repayments on the equity slice of the transaction. Shared equity mortgages are designed to give people access to more expensive property, which would be out of their reach using a traditional mortgage.

A shared equity mortgage could be right for you as long as you understand all the implications and are happy sharing the future capital appreciation from your property in return for lower monthly repayments throughout the term of the loan. The main products currently on the market want around 40% of the capital appreciation in  the property in exchange for a 20% equity investment.

Suitable for
Shared equity products offer a viable alternative for cash-strapped b homebuyers or owners.