What is a mortgage and how does it work?

A mortgage or a home loan is a type of loan where you borrow money from the lender to finance the purchase of a home or investment property.

When you borrow money from the lender , real estate is used as the collateral. The money borrowed is called the loan principal. The interest portion of the loan is determined by the home loan interest rate.

The borrower makes monthly repayments on the mortgage, with interest and principal, over a period of time which is usually between 25-30 years.

Finding the right mortgage

If you thought it was hard to choose the right property to buy, wait until you have to navigate the minefield of choosing the right home loan. To make it easier, here’s a checklist of things you need to look out for:

Am I buying as an owner occupier or an investor?

The kind of borrower you are will determine the type of loan you’re eligible for. If you’re buying a property as an investment to rent out, you’ll only be eligible for an investment home loan, which may have higher interest rates. Similarly if you’re buying a property to live in as your main residence, you’ll only be eligible for an owner occupier home loan.

How much deposit do I have?

If you don’t have the preferred 20% deposit saved , this can impact the kind of loan you’re eligible for as different lenders offer loans with different loan to value ratios (LVRs). The LVR is the percentage of the loan amount you’re able to borrow from the lender. Many lenders prefer an LVR of at least 80% or lower. If your LVR is higher than 80% (meaning you have less than a 20% deposit saved) you will need to pay Lenders Mortgage Insurance (LMI).

What type of loan do I want?

There are three main types of home loans : a basic, no frills loan with very few features; a standard loan with more features and flexibility than a basic loan; and a packaged home loan that bundles other products like credit cards into the loan. Package home loans

Is the interest rate competitive?

While it’s not the be all, end all of a home loan, a competitive interest rate is one of the top things to look out for. The lower your interest rate, the less interest you will have to pay over the life of loan. A lower interest rate can save you thousands (even tens of thousands) over your loan term.

Does the loan have an introductory rate?

Some home loans have a low introductory rate for the first few years before reverting back to the standard variable rate.

Do I want fixed repayments or variable repayments?

When interest rates are at record lows, locking them in with a fixed rate is tempting. However, fixed rate home loans can be less flexible than their variable counterparts, as you generally cannot make extra repayments or pay the loan off early without incurring an expensive break or discharge fee. With that said, many investors and first home buyers like fixed home loans because it offers repayment certainty for the first few years.

On the other hand, variable interest rates mean your rate will fluctuate over the life of the loan in line with market changes. If interest rates are going down, you get to take advantage of falling rates. Deciding whether to fix your rate or go with variable can be a bit of a gamble. If you fix your rate and interest rates fall, you’ll miss out on further rate cuts. A split loan can be a good option here. A split loan is where a portion of your loan is fixed and the other portion is variable, offering the best of both worlds. The split isn’t always a 50:50 split, it can be a 70:30 split or whatever is agreed upon by you and the lender.

Do I want principal and interest (P&I) or interest-only (IO) repayments?

A home loan is made up of two parts: interest and the principal amount borrowed. With principal and interest repayments, you’re chipping away at the amount borrowed as well as the interest portion of the loan, which means you’re paying down your loan faster than interest-only repayments. However, many investors prefer interest-only repayments because they’re tax-deductible and helps them to maximise their cash flow by keeping their repayments low.

What types of fees are there?

Fees aren’t completely avoidable but you can minimise them. The most common loan fees include application or establishment fees, late payment fees early exit fees, discharge fees, break costs (if you switch loans during your fixed rate term), redraw fees (if you use a redraw facility), and ongoing or monthly fees. Where possible, look for a loan that doesn’t charge any monthly or ongoing fees. While a $10 monthly fee may not seem like much, over a typical 30-year loan term that amounts to $3,600!

What loan features are important to me?

Another important thing to consider when taking out a mortgage is what features are on offer that could be important to you. Some mortgage features to look out for include an offset account , a redraw facility, the ability to make extra or lump sum repayments , the ability to split the loan , ability to get home loan pre-approval, etc.

How do I apply for a home loan?

If you’ve found your next investment property or the property of your dreams, the next step is to apply for a home loan. Here’s an overall guide of how this process works.

1. Compare home loans. Take the time to research and find a home loan that matches your needs and has a low interest rate.
2. Get pre-approval . This is where a lender gives you an estimate of how much you could potentially borrow for a home loan. Technically you don’t have to get pre-approval but if you’re early on in your home buying journey, having an insight into your borrowing capacity makes you an appealing buyer as it demonstrates you’re ready to pounce on a purchase. Keep in mind that pre-approval is not a guarantee that you will be approved for a loan.
3. Sign a contract of sale. Once you’ve decided to purchase a property, you will need to sign a contract of sale. This is the part where you’ll need to talk to a conveyancer who will look at the contract and guide you through the settlement process.
4. Apply for the mortgage . Once the contract of sale has been signed, it’s time to apply for a mortgage. For this you’ll need to supply your chosen lender with documentation proving your identity and income.
5. Approval and settlement. Once your loan application is formally approved, there’s not much to do now but wait until settlement day - the day you officially become the owner of the property. Before settlement day rolls around, your conveyancer will make sure all the necessary legal checks occur to complete the transfer of the property title and so on.
6. Move in! Congratulations, you’re a homeowner! Now the only thing you have to do is start making those mortgage repayments.

How are home loan interest rates calculated?

Interest on your home loan is calculated daily and is then charged to you at the end of every month. The lender does this by multiplying your loan balance by your interest rate and dividing this by 365 days (or 366 days in leap years). This figure is your daily interest charge, which is then multiplied by the number of days in the month to calculate your total monthly interest amount.

How much interest you end up paying will largely be determined by your home loan interest rate, which is why it’s so important to look for the lowest rate. An offset account can also help reduce the amount of interest you end up paying as any money in your offset account is ‘offset’ against your loan amount.

How can you save money on your mortgage?

We all want to pay less money on our home loans. You can save money on your mortgage by looking for a low interest rate, low fees, and using an offset account. Any money in the offset account is then ‘offset’ against your loan balance, reducing the amount of interest paid over the life of the loan.

Frequently asked questions

1. How much deposit is required for a home loan?

It’s generally recommended to have a 20% deposit saved, though some lenders may allow you to borrow with a deposit as low as 5%. However, if you have below 20% deposit you’ll need to pay Lenders Mortgage Insurance (LMI) which can amount to thousands of dollars.

2. What happens if I default on my home loan?

A mortgage default (missing a repayment by 90 days or more) will see you charged with a late fee of up to $200 and a default will be recorded on your credit report, damaging your credit score which could make it harder to take out future loans.

3. What are the requirements for a home loan?

To be eligible for a home loan you must have:

• A deposit of at least 5%, though 20% is widely preferred
• A stable income
• A good credit history
• A regular pattern of savings
• A lack of debts
• Bank statements and recent payslips
• At least two forms of identification (such as a drivers license and passport)
• Council rates for other properties you own (if any)
• Other documents such as the First Home Owner Grant, if eligible

4. What is the home loan process?

Applying for a home loan can be a lengthy and time consuming process, but it doesn’t have to be too complicated if you’re organised. Once you have saved a deposit, the process of applying for a mortgage generally involves the following steps:

1. Get pre-approval to gauge how much you can borrow
2. Find a property
3. Apply for a home loan
4. The lender completes a property valuation
5. The lender approves or rejects the loan
6. The lender sends you an offer
7. The loan is settled

5. What is an offset account?

An offset account is a transaction account linked to your home loan where any money stored in the account is ‘offset’ against your home loan balance, reducing the amount of interest charged on the loan.

6. What is a redraw facility?

A redraw facility is a home loan feature that gives borrowers the ability to withdraw any extra repayments they’ve made on their home loan to fund things like a renovation or other expense.

7. How much can I borrow for a home loan?

How much you can borrow for a home loan will depend on a few factors including how much you earn, your savings history, monthly living expenses, and outstanding debt you have. Whatever your borrowing power works out to be, it’s generally recommended that you borrow no more than 80% of the value of the property (a 20% deposit).

8. What is equity?

Equity in a home is the difference between the value of your property and the amount you owe remaining on the mortgage. For example, if your home is worth $800,000 and you still owe $300,000, your equity in the home is $500,000.

9. How do you refinance a home loan?

If you want a better deal on your home loan, shop around and compare new home loans, calculate the costs of switching and consider the length of the new loan. Once you’ve found a new loan, apply through the new lender and exit your old loan.

10. How long does home loan approval take?

The time it takes for a lender to approve your loan will vary from lender to lender, but it generally takes between four and six weeks with most lenders.

11. What is a credit rating?

A credit rating is a numerical score that represents your trustworthiness as a borrower. Your credit score can determine how much a lender is willing to lend you for a home and what interest rate to charge you. The higher your credit rating is, the more trustworthy you are as a borrower.

12. How do I pay off my mortgage faster?

There are many ways you can pay off your mortgage faster, including:

• Making extra repayments
• Making more frequent repayments
• Using an offset account
• Choosing a low interest rate
• Making principal and interest repayments instead of interest-only

13. What is the longest home loan term you can get?

The typical loan term in Australia is between 25-30 years, but there are a handful of lenders who offer loan terms of up to 40 years.