Risky home loans - what to avoid

We expose the traps of new types of loans, including 40-year mortgages and no-deposit home loans.
 
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  • Updated:5 Jan 2006
 

01 .Introduction

House made of money

With first homes averaging $430,000 and housing affordability at a record low, new types of loan may seem an answer to the prayers of desperate home buyers — but are they?

In this article, we take a look at these new loans:

  • 40-year mortgage Spreading your repayments over a longer period means lower minimum repayments, but you’ll pay much more in interest.
  • No-deposit home loan With these loans, the typical 20% deposit (about $80,000 for a $400,000 loan) is no longer required. Some banks lend you the full amount, and specialist lenders even offer you the money for legal fees and extras as well — but this comes at a high cost.
  • Guarantee As an example, your parents can become guarantors and put up their home as security to enable you to get a larger loan or buy without a deposit. But if things go wrong, the bank can sell your parents’ home as well.
  • Shared equity mortgage You can borrow up to 20% of the value of the property without paying interest, but when you sell it you have to pay back the original loan plus up to 40% of any increase in the value.

These new loan products are much more risky than standard home loans. While they promise to make home buying more affordable, they all have traps. For example, with a no-deposit mortgage you can be in a situation where your loan is well above the value of your home for a long time, meaning you’ll still owe money if you have to sell.

All these loans can get you into serious trouble unless you fully understand the fine print and have taken the right measures to use the loan to your advantage. In fact, the mortgage contracts that apply to most home loans can put home buyers at a serious disadvantage.

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


CHOICE wants fair home loan contracts

The mortgage contracts that apply to most home loans can put home buyers at a serious disadvantage.

A number of home loan contracts CHOICE reviewed gave the lender very broad rights to declare you in default of your contract. For example, one lender reserves the right to declare you in default if you lose your job or the value of your property decreases. If you are in default, the bank can ask you to repay the home loan immediately and, if you fail to do so, sell your house.

These contracts can be riddled with complex, legalistic and often outright unfair clauses. It’s unrealistic to think individual consumers could negotiate these terms with loan providers.

That’s why CHOICE has called on the Federal Government to introduce new national laws to protect consumers and ensure contracts are fair.

Have you seen a dodgy contract term? Join us in calling for new national fair contract laws.

 
 

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CHOICE crunched the numbers and found that extending a mortgage to 40 years doesn’t make it much more affordable, and costs you many thousands of dollars more in the long term.

  • On a $250,000 loan with an interest rate of 8%, your repayments would be about $100 per month cheaper: $1738 per month over 40 years instead of $1834 over 30 years.
  • But it’ll cost you. Over the 40 years you’ll pay nearly $585,000 on the $250,000 loan in interest alone, which is more than double the amount borrowed — and about $174,000 in interest more than you’d pay over 30 years.
  • If you borrowed $400,000 you’d pay $935,000 in interest over a 40-year term, about $278,000 more than over a 30-year term. Your repayment reduction is just $150 a month.

Comparison of repayments and interest of different mortgage terms

Mortgage terms table
Taking out a 40-year mortgage because you can’t afford the monthly repayments on a 30-year one doesn’t just cost you thousands more in interest. It’s also extremely risky and will backfire if interest rates go up.

An interest rate increase of just 0.5% would eat up the difference between the repayments: a $250,000 loan at an interest rate of 8.5% over 40 years would have a minimum monthly repayment of $1833 — just $1 less than the minimum repayment at 8% over 30 years.

It’s sensible to have an interest rate buffer of at least 2% when you buy. For example, in early 2002 banks’ standard home loan interest rates were 6%. By December 2007, they were 8.5%.

If you’d borrowed $250,000 in 2002 on a 30-year loan, you’d have started out with a minimum monthly repayment of $1507. But in December 2007 you would have been paying $1931 per month, and even more from January 2008 onwards, after major banks lifted their rates. If you were stretched to the limit to meet repayments in 2002, how much harder would it be now?

CHOICE looked at three financial institutions offering 40-year mortgages:

  • Savings & Loans Credit Union
  • Police & Nurses/Nurses First Credit Society
  • GE Money

On the upside, all three allow extra repayments, so you could take out a 40-year mortgage and pay it back over a shorter term, such as 30 or even 15 years, without any penalty.

CHOICE verdict on the 40-year mortgage

It makes sense to repay your home loan as quickly as possible. Extending a mortgage to 40 years doesn’t help much with affordability, as the monthly repayments aren’t much lower.

It can also get you into serious trouble if you budget to the limit on a 40-year mortgage; even a small rise in interest rates will hurt you badly. The only winner is the lender, as you’re paying them much more in interest.

03.No-deposit home loan

 

Several financial institutions offer a home loan for the full purchase price, or close to it. However, this comes at a cost:

  • Mortgage insurance usually applies if you have less than a 20% deposit.
  • No-deposit loans can also have a higher interest rate, especially compared to basic loans.

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. It’s worth taking the cost of mortgage insurance into account when shopping for a home loan, as it varies between lenders. See the variations we found, below.

Mortgage insurance cost comparison

Insurance table
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.

106% mortgages

Some lenders will even lend you more than your home is worth. For example, First Permanent offers a 106% mortgage. That means you don’t even need to save for legal fees and other costs. But does this make financial sense?

If you buy a home worth $236,000, you can borrow $250,000 on a 106% loan. At an interest rate of 8% on a 30-year mortgage, making minimum monthly repayments, it will take:

  • Over five and a half years before you owe 100% of the original value of your home.
  • 15.5 years before your loan is down to 80% of that value.

This calculation doesn’t take into account changes to house prices. If your home gains in value you’ll reach these percentages much sooner, but if it loses in value you’ll be deep in the red for a very long time unless you can make extra repayments.

HECS loan

A special type of no-deposit mortgage is the Graduate Home Loan. Offered by First Permanent, it enables you to pay back your HECS-HELP debt when you take out a home loan.

There’s no maximum amount you can borrow above the value of the property, with an average loan of 110%, according to First Permanent.

However, a 3.2% upfront fee on the full loan amount applies — for example, about $8000 on a $250,000 loan. You also have to pay a higher interest rate. And if you want to refinance within the first seven years you’ll have to pay another two fees, which come to 3% combined. All those fees, though, are just the beginning.

The main problem is that you’re paying a much higher interest charge on your HELP debt. For example:

  • With normal HELP repayments, if you have an income of $80,000 with a $20,000 HELP debt, you’re required to use 8% of your gross income to repay your HELP debt. Your debt is indexed (goes up) at a rate equal to the CPI — 3.4% in 2007. You’d need about three years to repay the debt and would pay about $1500 extra because of indexation.
  • If you repay the HELP debt as part of your mortgage, you initially get a 10% discount, so it reduces to $18,000. However, repaying this amount over 30 years at the current 8.9% interest rate would mean you’d pay about $33,600 in interest.

CHOICE verdict on no-deposit home loans

While these loans enable you to buy a house sooner, you need to take the cost of mortgage insurance into account. And with a loan for more than the value of the property, it’s crucial to make extra repayments to get some equity as quickly as you can.

Saving as much as you can before buying will lower the amount of mortgage insurance, or remove it altogether if you can save a deposit of 20% or more of the property’s value. It’ll also give you a wider variety of lenders and loans to choose from — and helps you get used to the discipline needed when you have a mortgage.

Your lender may ask you for a guarantee from someone, such as your parents, if it thinks you might not be able to cover the loan repayments yourself. If you don’t have a deposit, a guarantee may also mean you don’t have to pay mortgage insurance and have a wider choice of loans.

Guarantors usually use their home as security, and traditionally they were liable for the full amount of the home loan. Now new-style versions like the ANZ Family Guarantee allow the guarantor to limit their liability to a specific portion of the home loan, such as 20%. However, even in this case, if something goes wrong and the borrower gets into default, the bank can sell their home and/or the guarantor’s home.

The other problem with guarantees is that they can apply for the full period of the loan. During that time the situation of the guarantor (typically parents) can change. At the start of the loan they may still be in the workforce and have an income they can use to support the borrower in case of a problem (such as unemployment). However, later on they may be pensioners and their home is their only asset.

Another example of a 'home loan with guarantor' is CBA Family Equity. It has five options, three of which are variations of traditional guarantees. The other two options give the guarantor more security:

Second mortgage — the guarantor takes out a second mortgage on the borrower’s property, and is responsible for the repayments on it. If either fails to make loan repayments, the bank will sell the borrower’s property only.

Gift of loan proceeds — instead of giving a guarantee, a family member, such as your parents, takes out a separate loan on their property and gives the loan proceeds to you. The family member is responsible for the loan repayments on their loan only. Beware — if you’re on Centrelink support payments, you’ll need to check the gifting rules.

Checklist

As a guarantor you have rights; for example, you can ask to receive statements for the loan. Make sure you keep track of them, so you can act in case of problems. If you’re interested in a guarantee or being a guarantor, ask the lender:

  • What would happen in the worst-case scenario — could the guarantor’s house be sold, and under what circumstances?
  • Are there any extra costs, such as for a valuation of the guarantor’s home?
  • Can the guarantor be released from the guarantee and under what circumstances — for example, once the borrower has enough equity in the property?
  • What’s the cost of releasing the guarantor? Typically the borrower would need to refinance, and while the lender might waive the application fee, other costs such as mortgage stamp duty might apply.

If you decide to go for a guarantee check the Consumer Credit Code, which offers guarantors protection, at www.creditcode.gov.au. The code specifies a number of conditions that must be met before a guarantee for a loan could be enforced.

Bank wants to sell parents’ house

Anna and Bill (not their real names) from Melbourne live on a Centrelink pension. They originally come from Europe and have limited English skills. As well as owning their home, they owned a property that they gave to their daughter and son-in-law, Mary and Paul (not their real names), as a gift.

Mary and Paul took out a $380,000 loan with a bank. Anna and Bill say at that time they received a short visit from the bank manager at their home, asking them to sign some documents. They say they didn’t understand these documents were a guarantee, but understood it was something to do with the gift of the land.

Two years later the bank sent them a letter saying the loan was in arrears and demanding they pay it. Some months later the bank issued legal proceedings to enforce the debt against not only the borrowers, Mary and Paul, but also the guarantors, Anna and Bill.

The bank then obtained a judgment from the Victorian Supreme Court against one of the guarantors only, Anna, giving it the right to sell Anna and Bill’s family home. The Consumer Action Law Centre is currently negotiating with the bank on Anna’s behalf.

CHOICE verdict on loan guarantees

A guarantee is a very risky option for the guarantor. It’s important to get legal and financial advice and make a long-term plan — what will happen if, 10 years down the track, your child divorces their partner, for example? Consider the option of borrowing to lend to your children instead, or simply giving them money.

05.Shared equity mortgage

 

A shared equity or shared appreciation mortgage (SAM) works differently from a normal home loan:

  • You borrow, say, 20% of the value of the property as a SAM and instead of paying interest on it, you’re charged a percentage of the capital gain when you sell.
  • For the remaining percentage of the home’s value (minus your deposit) you take out a normal home loan.
  • This means your monthly repayments are lower than they would have been if you’d borrowed the whole amount under this loan.

What paying back a portion of the capital gain means is that as the value of the property increases, so also does the repayment amount. And, of course, it’s very hard to predict just how much the capital gain is going to be. For example, in the last 20 years in Sydney, annual changes in the value of house prices ranged from a decrease of 3.9% (2004/05) to an increase of 46.1% (1988/89).

The RISMARK/ADELAIDE BANK Equity Finance Mortgage (EFM) was launched about a year ago and is available in capital cities (and some other metropolitan areas) in all states except the NT and Tasmania. With it you can borrow 10%, 15% or 20% of the value of the property under a shared equity mortgage.

After 25 years, or when you sell the house, you have to pay back the initial amount you borrowed, plus 20%, 30% or 40% (double the percentage you borrowed) of the capital gain. If you make a loss, the lender covers 10%, 15% or 20% of the capital loss, which is then deducted from the amount you have to repay.

  • With this loan, if you’d bought a house worth $100,000 in June 1987 in Sydney and borrowed 20% ($20,000), on average it would have been worth $461,490 in June 2007, and if you’d sold it you’d have to pay back about $164,600. So the equivalent rate of interest you’d have been paying to RISMARK would have been about 10.6%.
  • If you’d taken a loan over the same period, the average standard home loan rate would have been 9.5%. Obviously with a standard home loan, you’d have had to make regular repayments over the whole period, whereas with RISMARK you only pay a lump sum at the end.
  • Over a shorter period the picture could look very different. For example, if you’d repaid the same loan of $20,000 after two years, following the massive jump in house prices in 1988/89, you’d have already owed $49,137, meaning you’d have paid RISMARK the equivalent of an interest rate of 45.8%. While this was a time with exceptionally high increases in house values, property values go in cycles and for a normal consumer it’s sometimes hard to guess at which point in the cycle you currently are.

There are a number of other downsides to the RISMARK/ADELAIDE BANK product:

  • At the time of writing, it could only be combined initially with a normal home loan from ADELAIDE BANK, which limits your choice of lender and products.
  • Due to the way the property’s value is calculated, you won’t necessarily get your money’s worth if you make any improvements, especially in the case of DIY renovations.
  • If you’re in default of the loan conditions and the house sells for less than you bought it, the lender doesn’t share the capital loss.

A possible alternative

A number of state government or state government associated lenders offer shared equity mortgages too. They often have much more generous conditions, but some aren’t available to everyone - they’re based on income and the price of the property.

CHOICE verdict on shared equity mortgage

A shared equity/shared appreciation mortgage is a very complicated product and very different ot other mortgage. It’s crucial to understand the fine print: you need both legal and financial advice. While a normal mortgage diminishes over time and is likely to be easier to pay in later years when your income increases, the shared equity repayment amount grows with the value of the property.

Obviously meanwhile you’re enjoying a better cashflow position as you don’t have to make repayments on the shared equity mortgage. But you become hostage to developments in house values. Shortly after a period of high capital growth is a very bad time to sell, even if your personal circumstances, such as having a baby on the way would make selling and upgrading the best option for you.

The bottom line is that the only way you come out on top is if you experience low or negaitve growth in the value of your home - but why would you want to invest in property if you expect that?

If you need advice about home loans or have a dispute with your bank consider talking to a financial counsellor:

  • ACT Care Inc. Financial Counselling Service, Ph: 02 6257 1788, www.carefcs.org
  • NSW Consumer Credit Legal Centre, Ph: 1800 808 488, www.cclcnsw.org.au
  • VIC Consumer Action Law Centre, Ph: 03 9629 6300 or 1300 881 020, www.consumeraction.org.au
  • WA Consumer Credit Legal Service, Ph: 08 9221 7066

Other places to help with disputes are: