How to choose a home loan
We help you navigate the mortgage maze.
No frills loan, or fully flexible mortgage?
Is it worth it to take the plunge into home ownership or is it better to rent and invest your hard-earned funds? Two academics claim they have found the answer: in the last three decades, buying a home gave you a better return in all Australian capital cities.
The economists from the University of Melbourne, Dominic Crowley and Shuyun May Li, crunched the numbers and compared buying and selling a house after ten years for each year in between 1983 and 2015 with renting and investing into a mix of shares and term deposits. They say, that while renting produced better returns in some capital cities for the decade from 1983, buying was clearly the better financial option from the early 1990s to early 2000s in all capital cities. The economists also suggest that buying is currently a good option for Sydney, Melbourne, Perth and Darwin.
But before you fall for the property spruikers, remember past performance isn't sure-fire evidence for future performance and Australian house prices have increased more than threefold since 1983 – even more in Sydney and Melbourne. No-one knows if that's sustainable. Also other research suggests that in other markets – for example, the US – renting is financially a better move than buying.
With home loan interest rates at historical lows it is certainly more affordable to repay a mortgage than ever, but one thing is for sure: you'll need a good home loan to make the most of it.
Types of home loans
Home loans are no longer just about signing up for 25 years and making regular loan payments – nor even just about trying to pay off the mortgage as quickly as possible. Flexibility and peace of mind are just as important, and there are a range of loan options that offer such benefits. However, these extras can cost money, and the key feature is still the interest rate.
There are three main types:
- Basic loans: no frills loans with few features and a low interest rate. Many now offer redraw facilities but there can be restrictions and fees, so a basic loan may not suit if you want to make extra repayments and access them later.
- Standard loans: offer more flexibility than basic loans. You can redraw any extra money you've paid in, for example, and have the option to switch to a fixed rate, or split the loan into a fixed and variable portion. They also often offer a 100% offset account. But you can often find a loan with a cheaper interest rate and similar features.
- Home loan package: standard loan with an interest rate discount of up to 1.2% depending on your loan amount, cheaper than many basic loans. The package normally includes a free transaction account and no annual fee credit card. However, high package fees apply of up to $400 per year.
Fixed or variable
At a time of historical low interest rates, low fixed rates sound tempting. But they can come with the downside of reduced flexibility. High break costs apply if you want to repay the loan early or relocate, and while some fixed loans allow some extra repayments, there are normally restrictions and some loans don't allow extra repayments at all, which can cost you by resulting in a high amount of interest over time.
Don't try to beat the bank – it's very hard to predict if you'll save with a fixed rate over the next three or five years.
Instead, ask yourself if you can afford higher rates. If not, fixing at least part of the loan could be a good option for you. A split loan offers the best of both worlds, allowing you to make extra repayments in the variable portion of the loan and still giving you the security of a fixed rate.
Watch the fees
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.
Don't be shy about asking your bank for a better deal. Interest rate discounts and fees waived are two things often on offer, especially if you're wanting to borrow a large amount.
Pay attention to the comparison rate, which takes fees into account, making it easier to compare loans.Some common fees include:
- Application fees: lenders may charge an upfront establishment fee and application fee. Ask the lender to waive these fees, or at least try to negotiate a discount.
- Valuation fees and lender's legal 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.
- Lender's mortgage insurance (LMI) can apply if you don't have an 20% deposit and it can cost you thousands of dollars. It doesn't insure you, but rather the lender (in case you default on the loan). It doesn't even absolve you from the debt – the insurer can chase you for it. Try to have as high a deposit as possible; even a small difference in the deposit can make a difference in the LMI cost.
- Monthly or annual fees: high ongoing fees can have an impact on how quickly you can pay back the loan.
- Break costs: fixed-interest loans can have high exit fees, especially if the variable interest rate is lower than the fixed 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'd paid the higher rate through to the end of the fixed term. This is called the 'break cost'.
Features to look for
- Extra repayments: Some loans – particularly those with a fixed interest rate – may limit the amount you can pay without getting charged a break fee.
- 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've just had a baby. Check the conditions, as sometimes you can only make use of this feature if you've made extra repayments, or you may have to make higher repayments after the repayment holiday to make up for it.
- Interest only: Paying interest only can be a useful feature for investors. It's usually available for five years but some loans offer it for up to ten years. It's risky, though, as generally you'd want to pay back the loan as quickly as possible to minimise interest charges and avoid owing more than the property is worth in case of a market downturn. Here's some more info on negative gearing.
- Mortgage offset accounts: 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.
For some features offered to first home buyers such as no-deposit home loans, family guarantees and 40-year home loans, check our report on risky home loans.
Still confused? Check out more info on home loans.