Different types of home loans and how they work

When it comes to home loans, one size doesn't fit all. Understanding the nuances of different loan types is crucial in steering your way to a home loan product that will tick all your boxes.

Each loan type - be it fixed or variable rate, or a more specialised loan like a green home loan or an SMSF loan - caters to specific financial needs and goals. That's why it's important to measure the range of options against your personal circumstances.

Here are the main types of home loans avaliable in Australia:

Owner-occupier home loans

An owner-occupier home loan is specifically designed for people purchasing a property they intend to live in as their primary residence. These loans typically feature more favourable terms and interest rates than investment home loans due to being a lower perceived risk for lenders.

Owner-occupier home loans come in various types, featuring fixed, variable, and split interest rates, allowing homeowners to choose a loan that best fits their financial situation and goals.

Here are some of the market's most competitive owner-occupier home loans:

Important Information and Comparison Rate Warning

Investment home loans

Investment loans are designed for purchasing properties intended as investments, rather than an owner's primary residence. These loans often come with different terms and higher interest rates due to their perceived higher risk. They may also require a larger deposit and have stricter eligibility criteria.

There can be tax benefits to taking out an investment loan, as the Australian Taxation Office (ATO) allows interest payments on an investment property loan be claimed as a tax deduction. This is one reason property is seen as an attractive investment option in Australia.

If you're considering buying an investment property or refinancing an investment loan, here are some of the lowest rate deals on offer now:

Important Information and Comparison Rate Warning

Rate types: Fixed, variable, or split rate home loans

Once most buyers have narrowed down their options to either an owner-occupier or investment home loan, next will come their interest rate preference:

Fixed rate loans

For those who value predictability or just want to lock in a low rate, fixed-rate home loans are a good option. They offer the security of knowing exactly what your repayments will be for a set period of time, generally ranging from one to five years. This means no surprises on your monthly budget, even if interest rates fluctuate on the wider market.

One of the most significant benefits of a fixed rate loan can be the protection it offers against rising interest rates. If the cash rate increases and market rates follow, borrowers with a fixed rate loan continue to pay at their lower, locked in interest rate. However, this can be a drawback if the official cash rate falls, as borrowers are then locked into a higher rate than is available on the wider market.

Fixed home loans tend to be less flexible than variable rate loans (see below), with limitations on extra repayments and potential penalties for breaking the fixed term early, known as break costs. Fixed home loans come in various types, including basic fixed rate loans, which offer fewer features but lower rates, and standard fixed rate loans, which may include additional features like offset accounts but at slightly higher rates.

Variable rate loans

On the other end of the spectrum are variable rate home loans, where the interest rate is changeable according to market conditions. Changes are usually in response to movements in the official cash rate set by the Reserve Bank of Australia (RBA). Variable rate loans see borrowers riding the economic waves - potentially benefiting from rates drops but requiring a savings buffer for if they rise. It's perfect for those who are comfortable with a degree of unpredictability and are keen to potentially capitalise on lower rates.

The defining characteristic of variable rate loans is their flexibility. They typically allow additional repayments at no extra cost, which can significantly reduce the total interest paid over the life of the loan. This feature can be appealing to those who anticipate improved financial circumstances or who wish to pay off their mortgage faster.

Variable rate loans often come with a range of features that can be tailored to suit individual needs. These can include offset accounts, which effectively reduce the interest payable by offsetting the loan balance against the money held in offset accounts, and redraw facilities, which allow borrowers to access extra payments they have made.

Split loans

For those who can't decide between a fixed or variable rate loan, a split home loan could provide the best of both worlds. This type of loan allows borrowers to allocate a portion of their loan amount to a fixed interest rate and the remaining portion to a variable interest rate. Essentially, it's a way of hedging bets against interest rate movements, giving borrowers a mix of security and flexibility.

Borrowers can decide how they want to split their loan - some may choose a 50/50 split, while others may opt for a different ratio according to their financial situation and risk tolerance.

A split loan is ideal for borrowers who are uncertain about interest rate movements or who want to manage their risk. It's also suitable for those who desire the stability of fixed repayments but also want to retain some of the flexibility that a variable loan offers, such as making extra repayments without incurring fees.

Here are some of the most competitive split rate home loan options advertised now:

Important Information and Comparison Rate Warning

Repayment types: Interest only or principal and interest home loans

Interest only (IO) loans

Technically not a home loan itself, an interest only home loan is a mortgage repayment type where the borrower is only required to pay the interest on the loan balance for a set period, usually one to five years. During this period, the principal - the amount borrowed - does not decrease. This results in lower monthly costs compared to principal and interest (P&I) repayments, making it an attractive option for certain borrowers, such as investors who may be more focused on cash flow management, who anticipate holding the property for a relatively short term, or who expect a significant rise in income in the future.

See also: 3 Key Benefits of Interest Only Home Loans

After the interest only period, the loan typically reverts to P&I repayments, meaning repayments increase as the borrower begins to pay down the principal. IO repayments can be risky if property values don't rise in the interest only period, as it could result in the borrower having less equity built in the property.

Principal and interest (P&I) loans

A principal and interest (P&I) home loan is the standard mortgage repayment type, where repayments go towards repaying both the principal amount borrowed and the interest charged to borrow it. This structure ensures the loan balance decreases consistently over time.

Initially, a bigger portion of the repayment goes towards the interest, but as the principal reduces, the interest component decreases while the principal repayment increases. This loan type is ideal for those looking to build equity in their property steadily, as it typically results in full loan repayment over the agreed term.

P&I repayments are widely chosen for long-term property investments and home ownership.

Green home loans

Green home loans, a relatively new addition to the mortgage market, are designed to encourage eco-friendly living, reduce energy consumption, and ultimately lower the carbon footprint of households.

They typically offer discounted interest rates or other financial incentives for purchasing or building homes that meet certain energy efficiency or sustainability criteria. The criteria might include solar panels, energy-efficient heating and cooling systems, or sustainable building materials.

Construction loans

As the name suggests, construction loans are specifically tailored to borrowers building or renovating homes. They differ from traditional home loans in that the loan is released in stages as construction progresses, rather than as a single lump sum. This phased approach, known as progressive drawdown, ensures borrowers only pay interest on the amount of money used at each stage.

Construction loans are structured to align with the various stages of building, such as laying the foundation, erecting the framework, and completing the interior. The lender typically requires inspections at each stage before releasing further funds. Once construction is complete, the loan usually reverts to a standard home loan.

This type of loan is ideal for those planning to build a new home or undertake significant renovations, offering a structured approach to financing the construction process.

Low deposit (high LVR) loans

Low deposit home loans, also known as high loan-to-value ratio (LVR) loans, are designed for borrowers who haven't saved the standard 20% deposit. Borrowers can take out these loans with a deposit as low as 5%, making home ownership more accessible for first-time buyers or those with limited savings.

However, these loans often require lenders mortgage insurance (LMI) to protect the lender against the higher risk associated with a smaller deposit. This insurance can add significant cost to the loan. First home buyers and single parents with deposits of 2% or more might be able to dodge the cost of LMI by turning to the Home Guarantee Scheme.

Low deposit loans can be a useful pathway into the property market, but borrowers should be aware of higher interest rates and additional costs, including LMI, and ensure these are manageable within their budgets.

Line of credit loans

A line of credit home loan allows homeowners to access the equity in their properties, functioning much like a credit card with a limit based on the property's value and the size of the mortgage on it. These types of loans provide flexibility, as borrowers can draw funds up to the established limit, repay them, and redraw again as needed. Line of credit loans can be beneficial for ongoing expenses, such as renovations or investments.

Interest rates on these loans may be higher than for standard home loans with interest calculated on the loan balance accessed. However, line of credit loans are becoming less popular on the home loan market. This is owing to the wide take up of loans with offset accounts and redraw facilities, which offer much the same function, often with greater flexibility and lower costs.

Low doc loans

Low doc loans cater to borrowers who may not have the traditional proof of income required for standard home loans, such as self-employed individuals or small business owners. These loans rely on alternate documentation, like bank statements or accountants' declarations, to assess a borrower's ability to repay the loan.

While low doc loans can be a solution for people with irregular streams of income, they often with higher interest rates and fees due to the increased risk to the lender. Additionally, borrowers might need a larger deposit or equity in an existing property to qualify.

Non-conforming loans

Non-conforming loans are designed for borrowers who don't fit traditional lending criteria, often due to having a poor credit history, irregular income, or being self-employed. These loans can provide a pathway to home ownership for those who might otherwise be excluded from the mainstream mortgage market.

However, non-conforming loans typically come with higher interest rates and fees to offset the increased risk, as perceived by the lender. These loans are often a last resort for those unable to secure a standard loan but can offer an opportunity to rebuild credit history or secure financing in challenging circumstances.

Other home loan terminology

When you're on the hunt for a home loan, you may come across terms that are can be loan features or marketing terms rather than a specific type of loan. Here are some common ones:

Refinance home loans

Refinance home loans are not a type of home loan, rather 'refinance' means simply switching from one home loan to another. This can be with the same lender or a different lender and is generally done in a bid to secure a lower interest rate or features that better suit a borrower's needs.

Some home loans marketed as 'refinance' home loans may come with inducements to lure borrowers to switch their loans, such as cashback offers, reduced fees, lower introductory rates, or bonus offset accounts.

Before refinancing to a new home loan (which may come with upfront costs in the quest for longer-term benefits), it is wise to speak to your existing lender to see whether it will match the interest rate or features you are seeking. This may save considerable expense and paperwork and ultimately secure you the type of loan you are looking for.

Guarantor loans

A guarantor home loan is one where another person, or persons, offers additional security to assist the borrower in obtaining a home loan. It effectively means another party agrees to 'guarantee' the loan should the borrower default on their repayments.

Many types of home loans can have guarantors added. In the eyes of lenders, a guarantor considerably lessens the risk associated with the loan and it can be the difference in having a home loan application approved or rejected.

However, different lenders will have different requirements associated with being a guarantor and it's highly recommended that both borrowers and guarantors are aware of the risks and responsibilities of such a loan arrangement.

First home buyer loans

First home buyer loans are not a specific type of loan but can be a marketing term for loan products that may be appealing to first home buyers. These loans may feature low interest rates, lower fees or LVR requirements, and sometimes come with cashback offers or discounts on lenders mortgage insurance.

These are not to be confused with loans offered by select lenders that are participants in the government supported Home Guarantee Scheme.

Niche home loan types

Then there are specially designed home loan products tailored for very specific needs, including:

SMSF loans

Self-managed super fund (SMSF) home loans are specialised mortgage products allowing SMSFs to borrow money for property investment. These loans are governed by strict legal and financial regulations. They offer a way for SMSFs to leverage their funds to acquire property, which can potentially provide rental income and capital growth.

SMSF loans often have higher interest rates and require a more substantial deposit compared to traditional home loans. It's also crucial for SMSF trustees to carefully consider the implications, ensuring compliance with superannuation laws and assessing the fund's ability to service the loan.

If you're considering an SMSF loan, we've compiled some of the lowest-rate offerings on the market:

Important Information and Comparison Rate Warning

Reverse mortgages

A reverse mortgage is a type of loan available to older homeowners, allowing them to access the equity in their property without the need to sell it. Generally available to those over a certain age (often 60), reverse mortgages enable borrowers to receive funds as either a lump sum, regular income stream, line of credit, or a combination of these. The loan amount, plus interest, is repayable when the borrower sells the property, moves out, or dies.

Reverse mortgages see interest compound over the period of the loan, which means the amount owed grows over time. As a result, the homeowner's equity in the home decreases as the loan balance increases. Reverse mortgages in Australia are regulated to ensure the borrower will not owe more than the value of their home, a feature known as a 'no negative equity guarantee'.

Reverse mortgages are often considered by retirees who want to supplement their income, fund home improvements, or cover healthcare expenses, while still living in their homes. However, it's important for potential borrowers to consider the long-term financial implications, including the impact on their estates and any potential effect on pension eligibility.

See also: Home Loans for Seniors

Bridging loans

Bridging loans offer a temporary financial solution for those looking to purchase a new property before selling their existing one. These loans fill the gap (hence the term 'bridging') in finances between buying a new home and selling the current one. They are typically short term, usually up to 12 months, and come with higher interest rates compared to standard home loans. The borrower generally pays interest only during the term, with the principal due at the end, usually after selling the original property.

Bridging loans are particularly useful for those who find their dream home but haven't yet sold their current one. However, bridging loans also require careful financial planning due to their short-term nature and associated costs.

If you're in the market for a new home and haven't yet sold your current pad, these bridging loan deals could be worth considering:

Important Information and Comparison Rate Warning

Choosing the right home loan type

As you can tell, there are many different types of home loan products in Australia and choosing which one is right for you ultimately boils down to what kind of borrower you are and what sort of property you're looking to buy.

Lenders also have their own specific requirements, and many will direct you to ensure you are taking out the right loan for your circumstances and financial situation. A mortgage broker can also be invaluable in helping you navigate the market and find the best loan for your needs.

See also: How to select the best mortgage lender for you

The key is search for a competitive interest rate and select the type of loan that aligns with your specific situation. Whether it's a fixed, variable, or a more specialised loan type, the focus should be on how well it fits your financial circumstances, lifestyle, and property goals. Bear in mind, it's not always about the lowest rate but finding the right balance between rate competitiveness and suitability for your unique needs.

Image by Dollar Gill via Unsplash