How to choose a home loan

Use our tips to negotiate the mortgage maze.
 
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  • Updated:19 May 2008
 

01 .Introduction

Toy house

Home loans are no longer just about signing up for 25 years and making regular payments — nor even just about trying to pay off the loan as quickly as possible.

For some people, flexibility and peace of mind are just as important, and there are a range of home loan options that offer such benefits. However, these extras cost money, and the key feature for most people is still the interest rate.

Finding the right mortgage may take some time, but it can save a lot of money and stress. This report will help you narrow down what type of loan will suit you best.

Please note: this information was current as of May 2008 but is still a useful guide to today's market.


How much can I borrow?

Lenders generally assess your present financial commitments and income to ensure you're capable of repaying the loan. However, don’t just rely on this, make your own assessment of whether you can afford the repayments.

It’s a good idea to give yourself a buffer, a good idea is to assess if you can still comfortably meet your repayment in case interest rates go up by 2%.

More help

  • Risky home loans gives the low-down on new types of loans marketed as being affordable, including 40-year mortgages and no-deposit home loans.
  • Consider using a mortgage broker. A good broker can explain your options, match your needs with lenders’ products, and assist with paperwork and loan application forms. Use our tips to ensure you get value from a mortgage broker.
  • Use our calculator to find out how much time and money you could save on your mortgage by making extra repayments.
  • For information on how to save on interest and pay your mortgage back faster check Fast-track your mortgage.
 
 

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02.Types of home loans

 

Introductory loans

These are also called honeymoon loans. To attract borrowers many lenders offer loans with a low rate for a period such as the first year. After this time the loan reverts to the current standard variable rate. During the honeymoon period interest rates usually are fixed.

Trap: there are usually exit penalties if you decide to cancel the loan, for example if you want to refinance to a basic loan with a cheaper interest rate within the first three to five years.

Standard variable-rate loans

With a variable loan you borrow the money for a set period of time, during which you make regular repayments. The interest rate (and therefore your repayments) can vary during this time.

Standard variable-rate loans are generally the most flexible — offering the opportunity to redraw any extra money you’ve paid in, for example, and the option to switch to a fixed rate — for three years, say. They also generally have few penalties if you want to pay off the loan early.

Tip: ask your lender for a discount on the variable interest rate. Usually you can expect up to a 0.7% discount if you borrow a large amount such as at least $250,000 or even more if you borrow $500,000 plus.

Basic variable-rate loans

Basic 'no frills' loans are on offer from a number of lenders. They offer a lower interest rate than standard variable-rate loans, but have fewer features.

Some basic loans are quite restricted and can have significant disadvantages — they may not even allow extra mortgage repayments above the minimum repayments.

Tip: there are now some basic loans available with good features such as a redraw facility.

Fixed-rate loans

The interest rate is fixed for a period, usually between one and five years, after which a new fixed rate can be agreed, or the loan can revert to the lender’s standard variable rate.

A fixed-rate loan can be wonderful if interest rates go up, but very expensive if they go down. Fixed rate loans may also penalise extra repayments.

Trap: if interest rates are expected to rise, the fixed rate is likely to be above the variable rate. If the rate is expected to fall, it could be lower. Make sure you understand break costs and other conditions before you sign. Look out for fixed loans that allow you to make extra repayments without penalties (for example $10,000 per year).

Split or combination loans

Part of your mortgage is treated as a fixed-rate loan. You may even have several fixed rates and one variable rate. For example with a $250,000 home loan you could have $100,000 on a variable rate, $50,000 on a two-year fixed rate and $100,000 on a five-year fixed rate.

Tip: if you’re worried that interest rates will rise, splitting your loan between fixed and variable rates can offer an element of security and flexibility.

Transactional mortgage (all-in-one loan)

This is the most flexible type of home loan. In essence it's a home loan from which you can pay money off and withdraw money very flexibly — because the mortgage is run like a bank account. Normally all your deposits like your salary go directly into your mortgage account and you have access to any amount above your repayments via EFTPOS, ATM or a chequebook.

Trap: this loan gives you flexibility. However, it may require considerable self-restraint and determination to stick to a schedule of payments and reduce your loan when you have such easy access to your money.

Online loans

Online loans with competitive interest rates and flexible features are now available from several lenders. One direct (owned by ANZ), CBA non-guaranteed subsidiary HomePath and others like them all offer loans which have low interest rates, and include many of the features you’d expect from a standard variable home loan, such as redraw facilities and the option to split your home loan between variable and fixed rates.

Tip: these loans aren’t available through brokers or branches, only online or by phone.

Low Doc home loan

Low doc loans don’t require the same type of documentation required for a standard home loan. For example, if you’re self-employed you may not be able to fullfill the requirements for a standard home loan but may qualify for a low-doc loan. The downside is that interest rates are usually between 1% and 3% higher and lenders may not let you borrow more than 80% of the value of your home.

Tip: some lenders revert your interest rate down to their normal variable rate after a period of one to five years.

Want to know more?

For further information about no-deposit loans, 40-year mortgages and other home loan options, see our report, Risky home loans.

Interest rates are just one of the costs to consider. You should also check the regular fees and charges. Fees and establishment costs can make a big difference to the amount you pay for your mortgage.

The comparison rate, or annualised average percentage rate (AAPR) is an 'effective interest rate' that takes into account these charges, making it easier to compare loans.

Some common fees include:

  • Application fees: lenders may charge an upfront establishment fee and application fee.
  • Valuation fees: lenders may also charge for a valuation of the property. If you're concerned you may not meet a lender's income requirements for the loan, ask them to check first, before going ahead with the valuation, as you may have to pay for the valuation even if your loan doesn’t get approved.
  • Exit penalties: check the costs for early repayment of the loan or refinancing. Many loans have no payout penalties other than normal discharge costs, but if they exist they can be steep, particularly in the early years. They can also be called deferred establishment fees or early settlement fees and can be a flat fee, several months' interest or a percentage (around 1%) of the original amount borrowed.
  • Lender's mortgage insurance: depending on how much you borrow compared with the amount you paid for your house, you may be required to take out lender's mortgage insurance. This insurance can be expensive, especially if you want to borrow up to 100% of the value of the property.

    Lenders usually require you buy this type of insurance if you borrow more than 80% of the property's value (known as the loan-to-value ratio). However, some may lend up to 85% without requiring mortgage insurance. But check if such loans come with a higher interest rate and whether you'll really be better off.

    Try to have as much of a deposit as possible, a small deposit versus no deposit can make a big difference. For example, on a $400,000 home loan, a deposit of just $20,000 (5%) could make your mortgage insurance around $4000 cheaper.

    A word of warning: lender's mortgage insurance doesn’t insure you, but the lender. It protects the lender if you default on the loan and your home is sold for less than your loan amount. The insurance will compensate the lender, but you’re still not absolved from the debt — the insurer can chase you for it.
  • Break costs: Fixed-interest loans can have particularly high exit fees, especially if the current variable interest rate is lower than the rate you're paying.

    If you want to get out of the mortgage, you may have to make up all the 'lost' interest the bank would have made if you had paid the higher rate through to the end of the fixed term. This is called the 'break cost'.

04.Features to look for

 

Home loans have many different features which can affect their overall cost and convenience. It's important not to judge them solely on the interest rate and up-front fee.

  • Extra repayments: Some loans — particularly those with a fixed interest rate — may limit the amount you can pay off your loan without having to pay a break fee. Paying an extra 10% could save you thousands of dollars. See our report Fast-track your mortgage.
  • Redraw facility: With many loans, if you make extra payments you can get the money back later. This can have considerable tax advantages and provide useful security as you can store your savings in your mortgage. Some redraw facilities are much easier to access than others — check whether you'll be required to apply in writing, how long it might take for approval to come through, and the costs involved.
  • Repayment holidays: Some mortgages allow you to take a 'repayment holiday' for a short period such as six months, for example, if you just had a baby. Check the conditions, sometimes you can only make use of this features if you've made extra repayment or you may have to make higher repayments after the repayment holiday to make up for it.
  • Other benefits: Lenders may give you an exemption from the fees and charges on other accounts such as a free transaction account.
  • Mortgage offset accounts: This lets you deposit money in an account and receive interest in the form of a reduction in the interest due on your loan. Because offset accounts don't actually pay you any money, they don't add to your taxable income — so like redraw facilities they offer tax advantages.

    However, always make sure that the offset account is worth the higher interest rate you might be paying. Some offset accounts can be used as your everyday transaction account, while others are only suitable for putting your savings into. And in some cases you may be able to have one or more of a range of ‘ordinary' accounts linked to your home loan all acting as offset accounts.