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How Do Home Loans Work?

Considering taking out a home loan? Here’s a guide to how they work.

Taking out a mortgage is a fundamental part of life for many Australian households. Most of us can’t afford the steep purchase price of a nice home up front, so we take out a large loan which we can then pay off over a long timeframe.

Home loans, also called mortgages, may be as common as the houses they’re used to buy, but that doesn’t stop banks from making them immensely complicated with various interest rates, comparison rates, interest-only periods, and pre-approvals. How do home loans work, you ask? Well, wonder no longer.

Here at Canstar, we research and rate more than 1,100 different home loan products based on the value they offer customers – so we know a thing or two about them! We’ve compiled this handy guide to help you understand everything about home loans – the concepts and terminology, the process of taking one out, and how to get the best deal you possibly can.

If any of the concepts we mention below aren’t familiar, check out our glossary of home loan terms to find out exactly what they mean. Or click on the link we’ve included in each section to read other articles explaining this topic in more detail.

What is a home loan?

 

A home loan, or mortgage, is a loan advanced to you by a lender in order for you to buy a property. The home loan is secured against your property, so if you can’t continue to pay the loan, your lender may require you to sell the property to settle the debt.

Typically, a home loan will be over a 25 or 30-year loan term, with regular repayment amounts that you pay fortnightly or monthly to pay off the loan over the contracted term.

To find out exactly how much you can afford to borrow on a home loan, use our handy home loan borrowing calculator.

We’ve written more to explain the different types of home loans here.

Canstar currently researches, rates and compares more than 1,100 home loans, to provide home buyers with the confidence to compare mortgages and find the best product:

Compare Home Loans

What do home loans cost?

The total amount you will pay on a home loan consists of three things: the principal (the amount borrowed), the interest the bank charges you and all applicable fees and charges. To find out how much your mortgage will cost each month, check out our home loan repayments calculator.

We’ve written more about how much a home loan costs over the course of your loan term here.

Interest rates

Home loan interest rates can vary significantly between home loan providers. Due to mortgages being very long-term loans, even small differences in interest rates can make a big difference to the total amount you will pay – so it’s important to negotiate a low-interest rate. There are two types of interest rates that home loan lenders will advertise:

  1. Interest rate: The interest rate is just the base rate of interest at which your bank will charge you. Your bank will multiply this percentage by your remaining home loan principal to determine how much you’ll need to pay in pure interest costs each month.
  2. Comparison rate (APR): The comparison rate includes the interest rate, payments, and most ongoing and upfront fees and charges in one rate reflecting the total annual cost of the loan, reduced to a single figure. On the Canstar website, all comparison rates for home loans are based on a $150,000 loan over 25 years.

Home loan interest rates can be either fixed or variable, each of which has several advantages and disadvantages that you can read more about here.

Fees

There are many home loan fees you should know about before buying – some lenders can charge more than others. Some of the more common home loan fees are:

  • Account-keeping fee: An account-keeping fee is a fee charged by lenders (usually monthly) to help cover the administration cost of maintaining the loan. It may be called a “service fee”. Some lenders charge an account-keeping fee instead of an annual fee. If you have an offset account on your loan, there may be an account-keeping fee charged on this account.
  • Annual fee: Some lenders charge an annual fee rather than an ongoing account-keeping fee on certain mortgages. These may be a “package loan” where a number of deposit and credit accounts are “packaged” up with your home loan under one administrative cost.
  • Redraw fees: If your home loan has a redraw facility (an agreement whereby you are able to redraw some or all of any home loan payments in advance) there may be a fee associated with doing so.
  • Application fee: Some lenders will charge you a fee for processing, or helping you through, your mortgage application.

There are several other types of fee out there, which vary depending on which provider you choose.

Compare Home Loans

Types of home loans

There are several different types of home loans which are suited to different people in different circumstances:

  • Fixed rate home loans
  • Variable rate home loans
  • Split home loans
  • Interest-only home loans
  • Line of credit home loans

Fixed rate home loan

A fixed rate loan simply means that the interest rate is “fixed” for a certain amount of time – commonly between 1 year to 5 years.

The main advantage of a fixed rate loan is that it gives you certainty of repayments over the fixed term. The interest rate is guaranteed not to go up (or down) over the fixed period, so you know exactly how much you’ll be repaying each month and can budget accordingly.

The main disadvantage of a fixed rate loan is the inflexibility. Generally, large additional payments cannot be made, and you may face a break fee if you decide to refinance your loan or sell the property before the end of the fixed term. With that said, the fixed rates on home loans are historically low in 2017 due to Australia’s record low official cash rate, making it a good time to look for a fixed home loan.

Variable rate home loan

A variable rate loan means that the interest rate will rise and fall with the market over the period of your home loan. This may be in response to movements in the official cash rate or may simply be a business decision by your financial institution.

The main advantage of a variable rate loan is flexibility. While you must meet your minimum monthly repayment, you can usually pay more if you want to. There is also no cost penalty if you decide to sell your property and move.

The main disadvantage of a variable rate loan is that your minimum repayment amount may rise or fall at any time. This makes it hard to plan and predict your repayments, which can be a real problem for those who are on a tight budget.

Split home loan

A split loan is simply a combination mortgage 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, providing both the flexibility of the former and the security of the latter.

When contemplating a split home loan, your biggest consideration should be how long you intend to stay in the home. If the intention is to stay only for a short while, a variable loan is more flexible and doesn’t entail “break fees”. On the other hand, if the intention is to live in the home long-term, a fixed rate may offer the certainty of repayments the borrower is looking for.

Try out our Split Loan Calculator here.

Interest-only home loan

An interest-only home loan is one where only the interest is paid, rather than both the interest and the principal. This type of loan can be useful for investors who can claim the interest as a tax deduction, or buyers who only plan on holding onto the property for a few years before selling it.

Interest-only home loans may not be a good idea for the average home buyer who is simply looking to pay less on their weekly repayments. The smaller the amount of loan principal that is repaid, the more overall interest you end up paying on your loan over the years. Generally, an interest-only home loan will have a short time frame (between 1 to 5 years) before it reverts to a principal and interest loan anyway.

Line of credit home loan

A line of credit is a loan borrowed against the equity in your home. It gives you the ability and flexibility to access the loan at any time, up to the agreed limit, and to pay money into the loan at any time. It is not generally a loan set up to purchase a property, but rather set up against the equity in an existing property.

How do I take out a home loan?

For a comprehensive list of things to do when taking out a home loan, read our applying for a home loan checklist.

The first thing you should consider before applying for a home loan is getting home loan pre-approval. This is essentially approval “in principle” for you to borrow up to a certain amount – your lender is officially saying that if you apply for a loan of that amount, you could be approved.

You might also look for home loan sign-up incentives which may offer you a discount on your loan – if only in the short-term. Don’t choose the first home loan you see, or dive into the market blind – compare home loans on our website:

Compare Home Loans

What are some tips for types of borrowers?

There are several reasons you might be looking to buy a property and take out a home loan. We’ve listed several of the most common types of buyer below, along with links to our articles detailing what you’ll need to know before you take the plunge.

First home buyer

If you’re buying your first home, it’s a big step – the first time you’ve ever gone through the convoluted process of buying a property and taking out a mortgage. For a comprehensive range of tips when buying your first home, check out our tips for first home buyers and things for first home buyers to think about.

Saving for a deposit

10 ways to save for a home deposit

What can count towards a deposit?

How much can you borrow to buy a house?

Applying for a loan

Choosing A Home Loan Checklist

What First Home Buyers should look for in a home loan

Home Loan Application Checklist

What are the real costs of buying a house?

Five steps to buying your first home

Insurance

What is Lenders Mortgage Insurance? (LMI)

What is mortgage protection insurance? (And why you don’t need it.)

Don’t forget to compare Home & Contents Insurance

Compare First Home Buyer Home Loans

Home builder

For many people, one of their dream goals in life is to build their own home. There is a huge appeal in constructing your own home – the whole floor plan, every detail, every construction material; all of it is up to you. If you’re planning to build a new home, check out some of our articles below.

What is a construction loan?

Construction Loans: What to be aware of

How to design your house to keep cool in summer and warm in winter

Traps to avoid when designing your own home

5 hidden costs of building

Building a home: Check for these inclusions

Compare Construction Home Loans

Refinancer

One of the more common changes that people make to their mortgage, refinancing is simply re-negotiating the terms of your mortgage to better suit your situation in life and how you plan to repay it. You might be earning more and looking to pay off your home loan faster, or retiring and wanting to change to a reverse mortgage – the reasons are many.

Why do people refinance their loan?

How to negotiate a better home loan rate

What does it cost to refinance a loan?

Refinancing: Check your Credit Rating

Compare Refinancing Home Loans

Upsizer

If you’re looking to start a family (or have recently done so!) then you’ll likely be looking to sell your current home and buy a larger one where there’s room for everyone, or potentially renovate your current house and make it larger. If you’re looking to upsize, check out our range of advice below on selling, buying, and renovating.

Selling your home? 10 ways to make a good impression

How to avoid auction mistakes

Package up products to save

How much will your mortgage cost?

Financing your renovation

Simple ways to add value to your home

Compare Refinancing Home Loans

Compare Construction Loans for Renovation

Investor

One of the more popular options in Australia thanks to incentives such as negative gearing, investing in property is widely (and accurately) regarded as a blue-chip investment which can bring you decent income in rent and significant capital gain. Things are somewhat different if you’re buying a property but not planning to live in it, so check out our articles below for advice.

Interest-only mortgages: pros and cons

Investment properties: Common buyer mistakes

Is a holiday home a good idea?

What is negative gearing?

Stamp duty on your investment property?

Hire a property manager or DIY?

Property through an SMSF

Compare Landlord Insurance

Compare Property Investor Home Loans

Compare Home Loans

Learn more about Home Loans

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