How do home loans work?

For most Australians, the upfront price of a home is out of reach. That’s why millions of homeowners have chosen to take out a loan that can be paid off gradually over time. This type of loan is called a home loan or mortgage.

It’s important to understand the various trade-offs that come from each different product. Educating yourself as much as possible on each type, is an effective way to ensure you have enough information to make an informed decision based on your needs. So, how does a home loan work?

What is a home loan?

In its simplest form, a home loan is an amount of money lent to an individual by a bank or other provider to fund the purchase of a property. The borrower agrees to pay back the money in instalments over time, plus an extra sum called interest.

To understand how home loans work, it’s important to become familiar with some key terms you are likely to encounter.

Mortgage vs home loan:

How a mortgage works and how home loans work has to do with the legal agreement between the borrower and the bank. Home loans by definition are simply bank loans required to purchase real estate, whereas the term mortgage refers to the legal agreement set up between the bank and the borrower that grants them conditional ownership of the property. So, a home loan is a fast-lane ticket to home ownership, whereas a mortgage is the agreement you make to get onto that lane in the first place.

Repayments:

Repayments are how much you will need to pay back to the lender, divided into instalments. Generally, the bank and the lender agree on a set repayment schedule during the mortgage negotiation. This typically varies between every week, fortnight or month.

Explore: Are weekly, fortnightly or monthly home loan repayments better?

Principal:

When a bank hands you money to buy a home, the amount that you borrow is referred to as the principal.

Explore: Principal and interest home loans – what exactly are they?

Interest:

Banks are businesses in their own right, and use tools like mortgages and interest in order to make an income from loans that they give out to customers. Interest is the monetary charge you must pay when borrowing money. It acts as a form of compensation to the bank for providing the opportunity to access large funds. The type of interest is agreed upon between the lender and borrower in the mortgage agreement. Interest is calculated using the principal amount, interest rate and loan term.

Explore: How is interest calculated on a home loan?

Comparison rate:

A comparison rate is an estimate of a loan’s total cost when interest, along with various fees and charges, are added up. Essentially, comparison rates work as a more accurate snapshot of the total amount borrowers can expect to pay. They’re usually expressed as an annual percentage and lenders are legally required to display them next to the interest rate.

Explore: What is a home loan comparison rate?

Loan term:

Both the lender and borrower agree on a term in which the loan is to be paid back. This typically ranges from a period of 20-30 years. While this may seem like a massive commitment at first, keep in mind that owning a property is often a long-term prospect. During this time, it’s critical to keep up to date with repayments. And, with each repayment, you are building equity, which is a valuable tool for financial stability. Be sure to check our Canstar’s article on home equity to learn more about the topic.

Loan type:

There are a range of different loan types, which have different structures and rules, depending on the borrower’s needs. It’s important for borrowers to understand the type of loan that they are applying for. This can have a big impact on how much you end up paying in the long term.

What types of home loans are available?

There are many different types of loans on the market. The two most common types are fixed-rate and variable.

Fixed-rate loans

A fixed-rate loan is one in which the interest rate is set on an agreed or ‘fixed’ amount, which is typically set in place for between one and five years. Because the rate is fixed, it typically means that the amount you pay each month remains the same and is unaffected by how interest rates move.

One of the potential advantages of having a fixed-rate loan is that it is typically more predictable than other types of home loans. Having the certainty of knowing what your repayments will be is a perk that many borrowers may value.

However, a fixed-rate loan can come with potential drawbacks. For one, fixed-rate loans tend to be more restrictive in terms of flexibility. Fewer features are often provided and you may be charged a break fee if you want to refinance.

Variable rate loans

What about when the interest rate is not set for a particular period? That’s where variable rate loans come into play. With these loans the interest rate may fluctuate over time depending on a number of factors, including how the lender decides to respond to cash rate changes. This means that you could potentially end up paying more than you expected each month.

The potential trade off? Flexibility. Variable loans typically offer more features than fixed-rate loans. These features could include such things as a redraw facility, the ability to lower interest rates with an offset account, and being able to make additional payments without penalty.

Split home loans

Can’t decide between variable and fixed-rate? There’s always the option of a split home loan to consider; which is essentially a mixed-version home loan that combines the flexibility of a fixed rate and security of a variable rate. With this type of loan, you nominate a portion that you would like to keep as a fixed rate, with the remainder at a variable rate of interest.

The outcome for a split home loan can be varied. You may end up paying more or less interest overall depending on how you manage your cash flow and make payments to the bank. We recommend exploring other articles on Canstar’s site which go into further detail on what a home loan is.

How to apply for a home loan

For many people, applying for a home loan can seem like an overwhelming process. This makes sense as purchasing a home is a big financial commitment.
This is why understanding the ins and outs of a home loan is so important.

By studying the broader ecosystem of loans, you can arm yourself with the tools to lead to an outcome more suited to your needs. One way to determine whether you’re in the right financial position to commit to a home loan could be to apply for pre-approval. This means applying to a lender for a loan before you know which property you want to buy, which can give you more of an idea of how much you would be able to borrow. However, it’s important to note that each time you apply for a loan, it is recorded on your credit file and may impact your credit score.

How to apply for home loan pre-approval

When you apply for a home loan, you may need to produce certain documents, such as:

• Proof of identification. In order to be considered for a home loan you will need to provide 100 points of identification. This can include a driver’s licence, passport or birth certificate.

• Proof of employment. Most financial institutions are going to require proof of income so they know you can pay off the loan. This can be provided in the form of payslips, bank statements or a tax return.

• Expenses. This usually takes the form of bank statements detailing which household bills you’ve been spending the most on.

• Insurance. Lenders require that you send them details of any insurance policies you may hold, such as life insurance or home and contents insurance.

Be sure to check out further articles on Canstar’s website when going through the loan application process. We recommend reading Canstar’s guide to applying for a home loan.

Home loan fees and costs

Interest isn’t the only extra cost that can arise. There could be a range of fees and charges associated with taking out a home loan. Here’s a brief list of some of the mortgage fees that you should be aware of:

• Upfront fees. These are the general establishment fees that banks charge to home buyers. The average cost is around $500 but this can vary depending on the institution you’re buying from with some estimates coming in closer to the $700-$1500 range. This includes valuation, legal and settlement fees.
• Ongoing fees. For the duration of your loan, the lender may apply ongoing fees that may seem small at first, but can really stack up over the course of a loan’s lifespan. Ongoing fees include monthly home loan fees and annual package fees.
• End-of-loan fees. Some lenders may include administrative fees when the time comes to end your loan.

Putting it all together

Understanding how home loans work is an important step on the road to home ownership. While this article provides a general overview of how home loans work, it could be a wise idea to undertake as much research as possible before committing to a home loan.

Trends like a recent increase in interest rates make it more important than ever to apply discretion and thoughtful consideration to long-term financial decisions – especially one as major as purchasing a home.

As part of your research, you may also like to compare what home loans are available on the market, looking at factors such as their interest rates and features. Canstar’s comparison tool may help you to do this.

And, be sure to read all important documents before signing on the dotted line, to ensure that you have a thorough understanding of how the loan you are taking on works, what the repayment schedule is, and what the penalties may be if you can’t pay back the loan. Documents to read include any terms and conditions, the Target Market Determination (TMD) and the Key Facts Sheet (KFS), which typically can be found on the lender’s website. If you are unsure of anything, ask the lender to clarify. You may also consider seeking suitably qualified financial advice.

Cover image source: Rido/Shutterstock.com.