What to look for in a home loan

When taking out a loan, you’re making a big commitment, and you’ll likely be paying your property off for many years to come, so it’s important to research as much as you can. Here’s a step-by-step guide on how to compare home loans. 

There are thousands of home loans on the market, so knowing how to narrow down the options can be a big help.

Here’s a checklist of questions to ask yourself when choosing a home loan:

1. Loan needs: How large is my deposit and what is the value of the property I want to buy?
2. Type of loan: What’s the best loan for my situation?
3. Ongoing cost of the loan: What is the interest rate on the loan?
4. Upfront costs of the loan: What fees apply to the loan?
5. Conditional costs: Do I need Lender’s Mortgage Insurance (LMI)?
6. Loan features: Does the loan have beneficial features?

1. Loan needs: How large is my deposit and what is the value of the property I want to buy?

Working out how much you want to spend on a property and how much of a deposit you can contribute is a good place to start when choosing a home loan. This will help you to narrow down the field of loans available, using the Loan to Value Ratio (LVR) filter on Canstar’s comparison tool.

There are two things you need to work out your LVR:

• Property price: By now you’ve probably been looking at real estate for a while, and have a rough idea of what you want to buy and how much you need to spend to secure it. It’s not essential to have an exact figure in mind (unless you know the actual property you want to buy), a ballpark figure will suffice.

• Your deposit: A housing deposit is quite a common bank savings goal for the average Australian. It’s important to note that how much you decide to contribute to the purchase in the form of a deposit typically influences the amount of confidence a lender will have in your ability to pay back the loan.

The Loan to Value Ratio (LVR) is calculated as a percentage of the property that you’re buying based on how much you put up for the deposit. This means that the larger your deposit is, the lower the LVR will be.

LVR can be expressed in this way:

(loan amount minus deposit) ÷ (total value of the property) x 100 = LVR

Consider this hypothetical example:

If your loan amount is $400,000 and your deposit is $80,000, and the total value of your the property you’re purchasing is $400,000, then your LVR will be 80%.

($400,000 – $80,000) ÷ ($400,000) x 100 = 80%

Certain lenders may charge higher interest rates if your LVR is above 80%. You may also be required to purchase Lenders Mortgage Insurance (LMI) based on the LVR (more on this, below).

Please refer to Canstar’s Home Loan Borrowing Calculator for further information. It’s important to note that lenders might not approve a loan for the amount you had hoped, as they weigh up things like your financial status, your credit history, and the type of property you want to buy in their approval process.

Explore further: Getting a home loan – what do lenders look for? 

It’s a good idea to also consider if you want to get home loan pre-approval, which could give you a more concrete picture of what property you can afford to buy.

2. Type of loan: What’s the best loan for my situation?

There are a few different types of home loans that are available, depending on the purpose and how interest is applied.

When shopping around for the right loan, it’s important to differentiate between whether you’re looking for property:

• to rent out, in which case you’ll need an investment loan or
• as a place to live, which will require an owner-occupier home loan.

There are also options as to how much of the principal you want to pay off:

• principal-and-interest (P&I) loan: where your repayments go towards paying off the amount you borrowed as well as any interest charges
• interest only (IO)  loan: where your repayments only go towards paying off the interest for a certain period of time, before your loan reverts to a P&I.

Then, consider how the interest is calculated. There are three general types.

• Fixed-rate loan: This type of loan comes with a fixed interest rate, which makes it easier for the borrower to plan over time and have certainty in their repayments. For more information, please refer to Canstar’s article on fixed vs Variable home loans.
• Variable-rate loan: A variable-rate loan is one in which the interest is not set in place and fluctuates depending on market conditions. Variable rate loans often have more features than fixed rate loans and offer more flexibility in certain conditions. However, they can also come with more uncertainty and borrowers may pay more in interest depending on market conditions.
• Split rate loan: Borrowers seeking even more flexibility may opt in for a split home loan which is a combination of both fixed and variable. This can be an excellent option for borrowers who want their loan partially fixed but still want the special features of a variable home loan.

Different loans can yield different outcomes depending on your situation. For example, fixed rate home loans may be considered by people who are looking for certainty when it comes to planning for their financial future. This is because fixed-rate loans are locked into a specified interest rate for a specified time, whereas variable rate loans’ interest rate can go up and down.

3. What is the interest rate on the loan?

Interest is one of the prime ways in which banks profit off loans. Understanding what your loan’s interest rate is can help determine how much you’ll end up paying in the long run. This is why choosing between a variable and fixed rate can make a massive difference on how much you end up paying overall. However, the lowest-rate loan may not necessarily have the features that you want in a home loan, which is why it’s important to compare loan options.

The interest on a loan plays a vital part in the loan’s comparison rate, which is the total cost of a loan when interest and fees are added up.

4. What fees apply to the loan?

When it comes to fees paid on a loan, you can usually expect to include the following:

• loan application or establishment fees
• mortgage registration fee
• lenders mortgage insurance.

There could also be other loan-specific charges, such as yearly or monthly package, settlement and valuation fees.

Explore: Home loan and mortgage fees you should know about

Home loan fees are not the only cost of a loan (besides the interest charges),  so make sure to familiarise yourself with the Costs of Buying a House in Australia. Excluding interest and deposits, new home buyers can expect to spend over $40,000 in extra fees on their home loan.

5. Do I need Lender’s Mortgage Insurance (LMI)?

Depending on your LVR, a lender may require you to purchase Lender’s Mortgage insurance (LMI), which is essentially a tool designed to protect the lender from loss if the borrower fails to make their payments.

LMI is often required for borrower’s who’s LVR is above 80%, as they’re typically considered a greater risk than borrowers who put down a larger deposit.

Several factors can affect the cost of LMI, such as:

1. the size of your home loan
2. your deposit amount
3. whether the property is for investment purposes or to live in
4. whether you are a full-time or casual employee
5. the insurer used by the financial institution.

Some borrowers may qualify for government schemes designed to help first home buyers and other groups with the cost of LMI, such as the First Home Guarantee. The Regional First-Home Buyer guarantee program, a special feature of this program includes being able to purchase a home with as little as 5% deposit.

6. Does the loan have beneficial features?

Paying attention to the features of a home loan is highly recommended for borrowers seeking success in the long run. Variable rate loans often have more features than fixed-rate loans, in addition to providing more flexibility. It all depends on the individual needs of the borrower taking out the loan.

Features can include:

• a redraw facility.
• an offset account.
• ability to make extra repayments
• ability to make lump sum repayments.

When shopping for the right home loan, the smallest of details can have a substantial impact in the long run.

Other factors to consider when looking for a loan:

• Taking on a home loan is a major financial decision. You may want to consider suitably qualified financial advice. Be sure to read all important documentation carefully, such as the Target Market Determination (TMD) and the Product Disclosure Statement (PDS), before signing any contracts. You can typically find these documents, as well as any other terms and conditions, on the lender’s website. Clarify any queries you may have with the potential lender.
• It’s highly recommended that potential borrowers check their credit score before settling on a home loan.
• Along with this, it’s always useful to examine the state of the market. For example, the Reserve Bank of Australia announced a series of cash rate rises, which means home loan interest rates are also rising. This increases the risk of homeowners facing mortgage stress. Different market conditions will yield different outcomes, so make sure to do as much research as you can before committing to a loan.

Original article by Terry Phelan. Cover image source: G-Stock Studio/Shutterstock.com