When searching the internet for information on home loans you may find that many websites assume you’re an expert, when most people aren’t! This is why we have put together a guide to home loans for total beginners!
What is a Home Loan?
A home loan is essentially a long-term loan whereby a lending institution provides money in exchange for some security (most likely the property you are purchasing) to allow you to purchase a property – this is often referred to as a mortgage. As the borrower, you are responsible for making repayments – these are usually monthly but can be fortnightly or weekly - which include interest charged by the lending institution. People can get home loans from a variety of lending institutions including banks and credit unions.
The amount of money that you will be borrowing for your home loan may seem daunting, however these types of loans have been specifically designed to be paid off very slowly (usually over several decades – often 30 years or sometimes longer) in regular payments you can afford – at least that’s the idea! Note that the interest rates charged on home loans are usually much smaller than credit cards. It wouldn’t be a good idea to buy a house on a credit card and pay it off over 30 years! It might seem a little crazy, but you can experiment with high interest rates using our repayments calculator. Try ramping interest rates up to 20% and see what happens!
When you take out a home loan you can choose the term of the loan - the term is how long you have to pay it off. You should bear in mind that the longer the timeframe that you nominate the more money it will cost you in the long run as you will be paying more interest. The most common loan terms are 20, 25 and 30 years.
How do Home Loans Work?
Home loan repayments usually consist of two parts – the principal and interest. The principal is the actual amount of money that you are borrowing and the interest is the fee that you are paying the lender for the privilege of borrowing that money. Many lenders offer the option to borrow an amount and only pay the interest off, meaning that if you did this you would still owe the same amount as you borrowed at the end of the loan. It may seem like a strange thing to do, however this is commonly used by investors for example who are banking on the property value increasing over a period of time, and the interest payments effectively represent the holding costs of their investment.
There are a variety of different home loan types (that we shall look at in more detail below); however in most cases as your principal amount decreases as you pay it off, the interest amount also decreases until you have eventually paid off both parts of the home loan.
How do Lenders Benefit from Home Loans?
Most banks and lending institutions make a large percentage of their revenue from home loans and they are an integral part of their business.
The home loan lenders benefit from home loans by charging interest and various fees to their home loan customers. Some of the typical fees to watch out for are establishment fees and ongoing fees. Interest and different fees can vary quite significantly between lenders.
Types of Home Loans
Unfortunately it’s not as simple as there being just one type of home loan! There are several options when it comes to choosing your home loan and what may be the right choice for one person may not be the right choice for you. They all have their benefits, costs and risks so you need to weigh up the pros and cons of each in relation to your own personal situation and needs.
We shall look at the two main types of home loans – fixed rate and variable rate home loans. Both of these refer to the way that interest is calculated, and ultimately how much you pay!
Fixed Rate vs. Variable Rate Home Loans
Fixed rate home loans mean that your interest rate doesn’t change throughout the length of your home loan for which the interest rate is fixed. This means that even if the economy were to change drastically and interest rates go up to 17% (it happened in the 90s!) then the rate you’re paying would remain the same. One down side is that you may fix your rate at say 8%, and variable interest rates may be at 6% – meaning that you’re paying more for the peace of mind! It's a matter of what works best for you.
Variable rate home loans have interest rates that adjust throughout your home loan term and reflect the situation of the economy. For example when the reserve bank puts the official cash rate up to counteract some dynamic they are seeing in the economy, chances are that if you have a variable rate home loan your interest rate will also increase.
There are pros and cons to both types of home loans. Fixed rate home loans have the benefit of giving you some increased financialcertainty – as you know what your repayments are each month. However, this benefit comes at a premium – usually fixed rate home loans have higher interest rates than variable rate loans. This is because although you are given financial security with a fixed rate loan, the lender takes on a significant amount of risk. You will not suffer if the interest rates go up. There may also be some reduced flexibility or a longer commitment when you enter into a fixed rate mortgage, for example you may incur additional fees for changing lenders.
There are sometimes hybrid options, for example variable rate home loan products can also give you a fixed rate initially for a certain period of time, sometimes up to 7 years, at the start of your home loan. After this time your home loan will change to a variable rate. This fixed intitial rate is often referred to as an introductory rate or "honey moon" rate. These are worth considering, however make sure you factor in the true cost and think through what happens when the honeymoon is over! Our home loan comparison calculator allows you to try out and compare scenarios with different introductory rates, terms and fees and see which options are likely to cost you less overall.
In almost every situation the interest rates charged for variable rate home loans are lower than fixed rate home loans - lenders are effectively getting you to commit to a rate which they have calculated will have this effect! In this way, a with a fixed rate you're betting that interest rates will go up above the rate you "fix" your homeloan at, in many respects a variable rate home loan is also a gamble - if interest rates did skyrocket then you wouldn't be subject to huge repayments. There is obviously no way that you can predict what the interest rates will be - especially not over a 30 year period! So once again, it's up to you to decide which approach is going to work best for you.
Applying for a Home Loan
Applying for a home loan is really quite straightforward. Once you have a general idea of what you are after, you can start approaching lending institutions or you may like to use a Mortgage Broker. Check out our article about the potential benefits of using a Mortgage Broker versus going direct to banks here.
All lending institutions and Mortgage Brokers will ask you a range of questions to establish whether or not you are a suitable applicant for a home loan, and if so how much you can borrow etc. These questions will include an assessment of your financial situation – such as salaries, assets, liabilities, dependent children and other loans.
The more supporting documents you can provide the faster your home loan application can be processed. Suitable documents include pay slips and a letter from your employer.
Home loan applications are processed within a range of timeframes, but range from within a few days to a few weeks.
What is Refinancing?
After you have taken out a home loan, you might decide later on when your situation changes or you’re unhappy with your current arrangement , to refinance it. Essentially refinancing your home loan means transferring your current home loan over to a different lender or different product from the same lender. Usually it is done to get a better deal, increase the loan amount to release equity in your property, or some other perceived benefits, .
When you take out your home loan it you may get the best deal at the time, but banks and lending institutions are constantly bringing out new products that may be able to save you significant amounts of money on your home loan.
Many people refinance their home loans so that they can transfer from a fixed rate loan to a variable rate loan and vice versa.
Note that there may be penalties for refinancing within a certain time period, so you must be sure to review your obligations under your existing loan arrangement prior to jumping in the deep end! If you’re not careful you could think you’re doing the right thing in saving some money on annual fees, but get slugged with some hefty penalty fees for exiting your existing loan agreement prematurely. T
So how can you refinance your home loan? Refinancing involves taking out a new loan and using some or all of the borrowed money to pay off your existing loan. If you are changing lenders then they will do all the hard work required to pay off your existing loan for you – you just reap the rewards!