What is a Home Loan?
What is a home loan? Interest rates, features, fees, and repayments explained. Plus, how to compare mortgages online.
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There are many different types of mortgages out there and various ways to repay. In this guide, you can learn about what those are, how interest works and a selection of available home loan features. You’ll also read about why it’s so important to compare home loans and consider the various benefits and costs of each one.
What is a home loan, and how does it work?
Home loans typically employ principal and interest repayments, which are pretty much exactly how they sound. Each time you make a mortgage repayment, you pay a portion of the loan principal down (that’s the amount you borrowed), but you also pay some of the interest too.
Home loans typically come with repayment terms of 25 or 30 years. They work much like any other form of secured finance: you repay the loan over time, along with interest, and eventually, you own your home outright. Home loans differ from other types of finance like car loans in that you’ll need to save up for a deposit.
How do interest rates work on home loans?
Every homebuyer pays a very personalised interest rate, which gets based on their financial circumstances, credit and employment history, and how much of a risk the lender perceives the loan to be. Before they even look at the homebuyer, however, lenders set a base or standard rate for each home loan product based on several factors.
The national cash rate is set by the Reserve Bank of Australia (RBA) and reflects wider economic conditions. Although lenders are influenced by the cash rate, it’s not the only factor that defines how they set mortgage rates. Banks are also affected by international markets because they alter how much it costs to provide funds to lenders. That’s why banks and other lenders don’t always adjust their rates when the RBA does.
When you take out a mortgage, to a degree, you can choose how the interest rate is structured throughout your term. It’s essential to consider all the possible implications of each option before you decide:
Variable rate home loans – largely track the cash rate and the other factors that influence lender base rates, so repayments can rise and fall, too. That’s an advantage when the cash rate is low but works out to be more costly when it rises.
Basically, your lender borrows money at the cash rate, then lends it to you with a mark-up. While the rate will be beyond your control when you have a variable rate mortgage, they do come with more features than fixed rate versions tend to have. They also offer more flexibility because it’s generally easier to refinance and extra repayments typically don’t get penalised.
Fixed rate mortgages – are another way to approach home loan interest. If your budget will be tighter for a while once you buy a house, you could consider applying for a fixed-rate home loan. They work slightly differently from other mortgages in that the lender will attempt to predict how interest rates might rise and fall and then offer you a consistent rate. You can select fixed rate terms usually from 1-5 years.
That means your repayments won’t change during that period, so it’s a lot easier to budget. It’s essential to bear in mind that you shouldn’t plan to refinance a home loan while the rate is fixed. Doing so will incur exit fees, so it’s best to wait until the fixed-rate period has ended.
Split rate mortgages are a cross between the first two options. Many lenders out there offer products that let you hedge your bets on interest rates. Let’s say you took on a $400,000 home loan. A split-rate mortgage allows you to fix the rate for some of the loan and stick with a variable rate on the rest. You could split it so that you paid a fixed rate on $250,000 and a variable rate for the remaining $150,000, for instance.
How do my home loan repayments work?
Once a lender has adjusted their standard rate based on a specific borrower’s circumstances and scenario, you repay your loan using an amortization schedule basis which means that every repayment includes a part toward your principal amount and some interest.
Principal and interest repayments
When you begin repaying a mortgage on a principal and interest basis, each repayment consists of a relatively high amount of interest and a relatively small amount of the principal, but that changes as the home loan progresses and you owe less money. Interest gets calculated on a daily basis and applies to the outstanding amount you owe. That means each month, you pay less interest. And more of your debt off. Lenders work everything out at the start of your loan so that your repayments don’t change – but the portions within them do.
Homebuyers can use amortisation and principal and interest repayments to their advantage. They most commonly do that by making extra repayments throughout the home loan term, reducing their debt and the interest they need to pay.
Interest-only repayments
Although they can work very well for investors, interest-only repayments can be problematic for owner-occupiers. Investor mortgages with interest-only repayments can be useful if you only plan to hold on to the property for a short time, or if you will be paying off your home loan early.
For owner-occupiers, problems can arise because a home loan is a long-term investment, and the biggest associated cost is interest. When you use interest-only repayments, you pay all the interest applicable to the principal each month – and every month. The principal doesn’t get paid down and you’re essentially just servicing an unchanging debt. That can be risky in a dynamic property market because if the value of your home falls, you can end up owing more than it’s worth – which is known as negative equity.
How do I compare mortgages, and what is a home loan comparison rate?
All home loans come with two different cost elements – the interest rate and fees. This is how you can assess mortgage costs using a comparison rate:
- Lenders charge various fees for different home loans. You’ll usually need to pay a setup fee, also called an establishment fee, which can range upwards from a few hundred dollars.
- Most home loan providers also charge a regular account maintenance fee. You can typically capitalise the establishment fee (include it in your home loan amount), and you’ll usually pay your account maintenance fee on a monthly basis, or along with your repayments.
- You’ll also pay a specific fixed or variable interest rate that relates to things like your personal circumstances and borrowing history, as well as the type of mortgage and repayments you choose.
- In Australia, all mortgages are displayed with two interest rates. One is the advertised rate while the other is known as the home loan comparison rate.
The beauty of comparison rates is that they include additional account and setup fees and then display them as a revised percentage – which includes the interest rate. They’re amazingly useful because fees can be hard to weigh up. If a lender doesn’t charge a setup fee, they could charge higher ongoing account fees, for instance – and that can add up over time to cost more.
For most borrowers, comparing home loans based on the above will give a very good indication of costs. However, in addition to establishment and account fees, you’ll need to be aware that other charges can apply in specific circumstances:
- Break fees only apply when you refinance your home loan or pay it down early during a fixed-rate period. It’s essential only to sign up for a fixed-rate term if you don’t plan to sell your home or switch lenders.
- Your lender may specify a period running from the start of your loan during which a discharge fee will apply when you refinance or pay down your borrowing – also known as an early exit fee.
Which different types of home loan can I choose from?
These days, there are many different types of specialised mortgage products on the market, so choosing the right one can pay dividends over the course of a relatively long repayment schedule, or when you want to improve your home or an investment property:
| Loan Type | |
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Many Australians work for themselves or as contractors, and many lenders offer home loans that take that fact into account. Full doc home loan options are pretty much the same as qualifying for a mortgage when you’re employed. Some lenders offer low doc home loan solutions for homebuyers who need to use alternative documentation. |
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House and land package mortgages basically split your home loan into several parts to suit the nature of building a new home. The first part is for the purchase of land, and the subsequent payments correlate with stages of construction, which get signed off as the build progresses. |
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Investment home loans are designed for homebuyers who want to buy a second property as an investment, or to make money from renting a home out – or both. They typically come with higher interest rates, but lenders can be more flexible in terms of interest-only repayments. |
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Low-deposit home loans are offered to homebuyers who need a higher LVR. Typically, anything above 80% is considered to be a low-deposit home loan. Some lenders consider applications up to 95%. |
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Family pledge home loans |
Parental assistance home loans are for homebuyers lucky enough to have a parent or immediate family member who will provide security for their borrowing. Unlike guarantor loans, family pledge mortgages allow for only the deposit portion of the home loan to be guaranteed if that’s what the homebuyer prefers. That means LMI can be avoided without the guarantor having to provide security for the entire home loan. |
What home loan features can I choose?
Home loans come with a couple of potentially useful options, depending on what you want to achieve during ownership and how much savings you already have.
- Offset accounts work in much the same way as a standard bank account, but they’re linked to your home loan. The way that benefits borrowers is to do with how much interest they pay on a regular basis. Let’s say you still owe $600,000 on your mortgage. Under normal circumstances, you’d need to pay the home loan interest rate on that amount each month, but that’s where an offset home loan helps. Any money deposited in an offset account works to reduce the figure the interest rate applies against. For example, if you keep around $60,000 worth of savings in your linked account, that will reduce the interest on your monthly mortgage repayments by 10%.
- Offset accounts are useful for: Avid savers who want to reduce the amount of interest they pay on a home loan
- A redraw facility is a great home loan feature for renovators. You can’t access more than 80% of your property’s value, but you can make extra repayments during the term if needed and then access the resulting equity for any purpose you need. To use a redraw facility on a relatively new mortgage, you may need to pay more than the agreed monthly repayments. You can do that in various ways. For instance, you could pay all or some of your tax refund or annual bonus each year or switch your repayment schedule to a weekly system, which will gain you several thousand dollars annually on most home loans. You can also gain a lot of equity each year simply by switching from a month-based repayment schedule to a week-based one:
| Loan | Payments | Amount | Number | Annual Total | Extra Equity |
| $800,000 | Monthly | $4,200 | 12 | $50,400 | $0 |
| Weekly | $1,050 | 52 | $54,600 | $4,200 |
How much of a deposit do I have to make for my home loan?
Before you apply for a home loan, it’s important to consider how much you’ll have to pay for your deposit. Deposits and how much you save can have long-term cost implications, plus you can incur extra expenses when you use a smaller down payment. Basically, the more you save for a deposit, the less you’ll need to borrow and the cheaper your home loan will be.
You should aim for at least a 20% deposit because that’s the minimum you can use without paying lenders mortgage insurance (LMI). LMI is there to protect the lender against defaults. LMI kicks in when your loan to value ratio (LVR) rises above 80%. LMI is a cost totally independent to the rest of your mortgage costs and gets based on a percentage of the total value of your loan, which rises depending on how far above 80% LVR you go. (Insurers vary and the table contains estimated figures):
| Home Value & LVR | Up to $300,000 | $300,001 - $500,000 | $500,001 – 750,000 |
|---|---|---|---|
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80% |
0% |
0% |
0% |
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85% |
0.9% or loan amount (Max: $2,700) |
1.10% of loan amount (Max: $5,500) |
1.3% of loan amount (Max: $9,750) |
|
90% |
2.2% of loan amount (Max: $6,600) |
2.8% of loan amount (Max: $14,000) |
3.2% of loan amount (Max: $24,000) |
Lenders view home loan applications with a larger deposit as a safer prospect than mortgages with a small down payment. That not only makes 80% LVR home loans cheaper than low-deposit mortgages, it also means you’re more likely to qualify for a home loan if you save a decent deposit before you apply.
Remember, when you’re saving for a deposit, don’t forget to take additional up-front costs into account. Typically, homebuyers should plan to pay about 5% of the purchase price of their new home on additional expenses:
- Stamp duty differs from state to state and gets based on the value of your home. It’s payable upon completion of the conveyancing.
- Transfer fees are payable when the title of your new home gets assigned to you.
- Conveyancing is necessary to make sure that your sale goes through smoothly and legally. It involves the conveyancer liaising with the vendor’s agent and also carrying out any searches related to the title on your new home.
