Whether you’re a first home buyer or haven’t been through the home-buying process in a while, figuring out which home loan is right for you can be daunting. Making sense of everything you need to consider – from interest rates to loan terms, features and more – is no easy feat, especially if you’re new to the whole process.
We’ve put together this guide to home loans to help make finding the right home loan easier.
How do home loans work?
Most of us can’t afford the cost of buying a home upfront, which means taking out a home loan – also known as a mortgage – is a necessary part of the home-buying process.
In simple terms, a home loan is a loan advanced to you by a lender so you can buy a property. The home loan is secured against your property, which means if you can’t repay the loan, your lender may require you to sell the property to settle the debt.
Home loan lenders can be banks or other financial institutions. Generally, a home loan will be over a 25- or 30-year loan term, with repayments to be made fortnightly or monthly to pay off the loan over the agreed term.
How much can I borrow for a home loan?
Most lenders use the same basic formula when calculating your borrowing power:
Gross income – tax – existing commitments – new commitments – living expenses – buffer = monthly surplus
This formula helps determine your serviceability, which is your ability to meet loan repayments, based upon the loan amount, your income, expenses and other commitments.
Lenders will assess the repayments of your new loan at a rate that is typically 2% to 3% above the actual interest rate that you initially agree to. This is to ensure that you could still pay off your home loan if the interest rate were to rise in future.
Typically, the amount you can borrow for a home loan is the purchase price of the property minus your deposit amount. In some cases, the lender may value the property below the offer price, in which case their loan offer may be less that the property offer price. In this situation, you have three main options:
- Show your lender that you have sufficient funds to cover the shortfall and allow them to lend you the rest.
- Compare valuations with other banks. Depending on whether you can borrow with that bank, you may have an option to choose a different lender.
- Use equity from another property – either a property you own or by asking a family member to go guarantor.
However, the above scenario is usually avoidable if keep your price offer at a level that is reasonable to both your budget and the local market.
How does home loan interest work?
There are two parts to a home loan: the money you borrow (the principal) and the interest charged by the lender. Home loan interest is usually calculated daily and then charged to you at the end of each month or fortnight. It’s important to consider the interest rate when taking out a home loan, as it can significantly impact how much you end up paying over the lifetime of the loan.
There are several factors that can impact interest on your home loan:
- The Reserve Bank of Australia’s official cash rate – The interest rate on your loan is based on the official cash rate set by the RBA on the first Tuesday of each month (except January). Usually, a drop in the cash rate will prompt lenders to lower their interest rates, while an increase in the cash rate can lead to interest rate hikes.
- Your loan amount – The more you borrow, the more interest you will need to repay. For example, 4% of $1 million will always be larger than 4% of $500,000.
- Repayment amounts and frequency – The more frequently you make repayments, the less interest you will pay on your loan. Paying off more than the minimum repayments will also reduce the total amount of interest you need to pay.
- The outstanding loan amount – As you pay off the loan, you will be paying interest on a decreasing loan amount, and as such, your interest payments will gradually reduce.
- An offset account – Some home loans come with a linked offset account, which allows you to reduce the amount of interest you pay on your loan by “offsetting” the total loan amount against the money in the account. For example, if you borrow $400,000 from the bank but you have $80,000 on a linked 100% offset account, you will only pay interest on $320,000.
Types of home loans
There are several different types of home loans to choose from. The three most common types are as follows:
Fixed-rate home loans
A fixed-rate loan means that the interest rate is “fixed” for a certain amount of time – typically between 1 year to 5 years.
The main benefit of a fixed-rate loan is that the interest rate is guaranteed not to change over the fixed period, so you know exactly how much you’ll need to repay during that time.
Recently, many buyers have been opting for fixed-rate home loans due to Australia’s historically low cash rate – and subsequently low home loan interest rates.
Variable-rate home loans
A variable-rate loan means that the interest rate rises and falls with the market over the lifetime of your home loan. This could be in response to changes in the official cash rate or purely a business decision by your lender.
One benefit of a variable-rate home loan is that you can usually pay more than your minimum repayment if you want to (thus paying off your mortgage faster and decreasing the total interest payable). There is also no cost penalty if you decide to sell your property and move.
Split home loans
A split loan offers a combination of the two types above, whereby part of your home loan is on a fixed rate and part is on a variable rate. A split loan can be a good middle ground between a variable rate and a fixed rate home loan.
What is a comparison rate?
You’re likely to come across the term “comparison rate” when shopping around for home loans. In a nutshell, the comparison rate helps you work out the true cost of a loan. It reduces the interest rate, fees and charges relating to a loan to a single percentage figure.
This is useful because the home loan with the lowest interest rate isn’t always the cheapest option when you factor in other costs such as fees. The comparison rate allows you to compare the true cost of loans from different lenders to find one that’s most affordable.
How do I find the best home loan?
Although the interest rate is important, finding the best home loan for you takes some research. Here are some of the key factors to take into consideration:
There are numerous fees associated with taking out a home loan and they can add up over time. Some of the most common fees to look out for include:
- Application fees
- Annual fee
- Account-keeping fees
- Legal fees
- Settlement fees
- Exit fees
- Break fees (for fixed interest home loans)
Different lenders have different rules for making home loan repayments. For example, if you have a fixed-rate home loan, you may not be able to pay any extra than the minimum repayments during the fixed-rate period.
Some home loans are relatively basic, while others offer a suite of features. Features to consider include:
- An offset account – This is a transaction account that is linked to your home loan and reduces the amount of interest payable on the loan.
- The option to redraw – A redraw facility allows you to borrow back extra money you've already repaid.
- Extra repayments – This could be useful if you want to make additional payments to pay off your loan faster.
- Repayment holiday – Some lenders allow a break in repayments or a temporary reduction in the repayment amount.
It’s a good idea to have a look at home loan comparison websites to see what’s available, or talk to a mortgage broker who can help find the right loan for your circumstances.
What happens to my home loan if I decide to sell?
When you own a house with a mortgage, you may end up selling your property at some point before it's paid off in full. When you sell your home with a mortgage, you’ll usually have to arrange for the mortgage to be discharged before settlement. This involves completing and signing a formal discharge of mortgage form and providing it to your lender.
What happens next depends on whether you sell your house for greater or less than the value of the mortgage.
If the market value of your property is less than the remaining amount on your home loan, this is called “negative equity”. If you have negative equity in your home and need to sell it, the remaining home loan amount will need to be paid off at the original rate.
However, many people selling a house in Australia make a return by selling their property at a higher price than they purchased it for. In this case, the remaining proceeds will go to you, minus the cost of discharge fees, any outstanding rates and utility fees, as well as fees to your solicitor or conveyancer and real estate agent.
Whether you’re thinking of buying or selling, see why Upside is one of the top-rated real estate agents in Australia. Check out our property listings, or start your journey with a free property appraisal.