What is a home loan?

ALASDAIR DUNCAN

A house is one of the biggest purchases you can make throughout your life, and if you’re in the market to buy one ‒ either to live in, or to use as an investment property ‒ then chances are, you’ll need to take out a home loan.

While it is possible to purchase a property outright by paying the full amount in cash, the majority of Australians are not likely to be in a financial position to do this. For this reason, most people will take out a home loan to finance the purchase of a property. In this article, key questions we answer include:

What is a home loan?

A home loan is an amount of money lent to an individual borrower by a bank or other loan provider, in order for that individual to finance the purchase of a property. The lender and borrower will agree on a term in which the loan is to be paid back ‒ typically, this will be a period of 25 to 30 years. The lender and borrower will also agree on a repayment schedule, which will generally be fortnightly or monthly, but can vary.

In addition to the principal (the amount of the loan itself), a borrower will usually be required to pay interest. The type of interest payable will be determined by agreement between the lender and the borrower, and there are various types of interest rates, including fixed and variable, which will be discussed in further detail below.

A home loan is typically secured against the value of property itself. This means that if a borrower falls behind in their repayments or is otherwise unable to pay the loan back, the lender may compel them to sell the property in order to settle the debt.

What is the difference between a home loan and a mortgage?

The terms ‘home loan’ and ‘mortgage’ often seem to be interchangeable, so is there a difference? Yes, there is a distinction between the two, and it’s important to clarify the difference, even if it may only seem semantic.

The term ‘home loan’ refers to the money that someone borrows in order to purchase a property. The term ‘mortgage’, on the other hand, refers specifically to an agreement between a borrower and a lender, in which a property is used as security for a loan.

Simply put, a mortgage exists in order to protect a lender from default. If a borrower (mortgagor) falls behind in their home loan repayments, their lender (mortgagee) has the right to sell the property on which the loan is secured in order to recoup the balance of the loan.

What types of home loans exist?

In Australia, home loans are typically classified in one of two different ways ‒ either by the type of interest rate, or by the purpose of the loan itself. We will consider each of these categories in detail below.

What home loans are available by interest type?

The two most common types of interest rate are fixed and variable, but there are a number of other options beyond these. Here, we will consider what these types of loans are, as well as some of the advantages and disadvantages of each, taking into account:

What is a fixed-rate home loan?

A fixed-rate loan is one in which the interest rate is set or ‘fixed’ for a certain amount of time – this will most commonly be a period of between one to five years. This means that, over the course of the loan period, your repayments will remain the same and will not go up or down, regardless of how interest rates move.

A key advantage of a fixed-rate loan is the certainty of knowing your repayments will be the same each month, even if interest rates rise. A key disadvantage is that fixed-rate loans often come with fewer features than variable rate loans, and you will typically be restricted in your ability to make extra repayments.

Similarly, if you choose to sell your property or refinance your loan before your fixed term is up, it is likely that your lender will charge you a break fee. You can read more about the potential cost penalties of breaking a fixed-rate loan.

What is a variable-rate home loan?

A variable-rate home loan is a loan in which the interest rate is not set. Instead, it will vary over the period of the loan, rising and falling depending on the cash rate. An advantage of a variable-rate home loan is that it may come with a variety of features, including a redraw facility, the ability to use an offset account to lower your interest payments, and the ability to make extra repayments without a penalty. There are typically no break fees associated with a variable rate loan, but other fees and charges can apply.

A key disadvantage of a variable rate loan is that the minimum payment required can rise and fall. This may not be desirable if you wish to have the certainty of knowing exactly how much you will pay back each month.

What is a split home loan?

A split loan allows you to effectively divide your home loan into two separate loans, one with a fixed rate and one with a variable rate. Much like Miley Cyrus and Hannah Montana, a split loan could allow you to enjoy ‘the best of both worlds’, combining the flexibility and features of a variable rate with the certainty and security of a fixed rate. Keep in mind, however, that you may be worse or better off financially with a split home loan based on the overall interest that’s payable over your loan term. The advantages of ‘splitting’ your home loan may offset this for some borrowers.

If you have a split loan, then your repayments on the fixed portion will remain the same throughout the term of the loan, while your repayments on the variable portion could go up or down, depending on the cash rate. Should you choose a split loan, you will generally be able to choose the percentage split between fixed and variable, although it is worth keeping in mind that split loans are not available on all home loan products.

What is an interest-only home loan?

An interest-only loan differs from standard loans in that the borrower is not required to make repayments on the principal of the loan ‒ instead, only the interest is payable. In general terms, an interest-only loan will have a short term of between one to five years before it reverts to a standard principal and interest loan. This type of loan can be useful for investors who wish to claim the interest as a tax deduction, or for buyers who only intend on holding onto the property for a few years before selling it.

Note that an interest-only loan may not be suited for buyers who intend to live in a house on a long-term basis, as the smaller the amount of loan principal that is paid off, the higher the overall interest cost may end up being to borrowers over the years.

What home loans are available by purpose?

There are a variety of reasons you might take out a home loan ‒ it might be that you are taking your first steps on the property ladder, or you may be an existing homeowner who is seeking to expand your portfolio with an investment property. We will consider the various types of loans for purpose below, sharing:

What is a first home buyer home loan?

A first home buyer loan is one that’s designed for people who are looking to get into the property market for the first time. Loans for first home buyers can fit into any of the various interest categories mentioned above, but what makes them unique is that home loan providers will often offer special deals and discounts to attract first home buyers. These can range from rebates on the purchase price of the home to rebates on conveyancing costs, and guarantees of no establishment, ongoing or annual fees. First home buyers may separately be eligible to participate in schemes such as the First Home Loan Deposit Scheme (FHLDS), along with the First Home Super Saver Scheme (FHSS Scheme).

What is a line of credit home loan?

A line of credit loan is a loan that enables people who already own a property to borrow money against their equity. Equity refers to the difference between the current value of the property and how much you have left to pay your home loan, representing the value of the property that you personally own (not the lender).

A line of credit loan functions somewhat in the same way that a credit card does – it will allow you to borrow money up to a pre-approved limit, without needing to apply for a loan each time you wish to draw on it. Banks will typically lend you 80% of the value of your home, less the debt you still owe against it ‒ this is what’s known as your usable equity.

A line of credit loan can be used for a variety of purposes, and may be suitable for homeowners wishing to fund renovations on their property or make a large purchase such as a car, or for investors wishing to have funds on standby in case opportunities arise. You can draw from the loan and pay money into it at any time you wish, and you will typically only pay interest on the amount you have drawn.

What is a bridging home loan?

A bridging loan is a special type of short-term loan that exists to ‘bridge the gap’ for people who are transitioning between homes. If you have bought a new property and intend to sell your current one but have not yet done so, a bridging loan can help you cover the purchase of the new property as you arrange the sale of your first.

A bridging loan is generally an interest-only loan, the value of which is calculated based on the equity in your current property. These types of loans typically come with a limited term, and consumers should be aware that, as a condition of the loan, lenders will often charge a higher interest rate if your existing property is not sold within a certain timeframe.

What is a construction home loan?

A construction home loan is designed for people who are building a home from scratch. Once a construction loan has been approved and the build is underway, lenders will make progress payments throughout the various stages of the process. A construction loan will typically be interest-only during the construction period, and then revert to a standard principal and interest loan.

As the loan is being progressively ‘drawn down’, interest and repayments will only be charged or calculated on the funds used so far. The total loan amount is partly based on how much the property will be worth once it is fully built.

What is an owner occupier home loan?

An owner occupier home loan is a loan for an applicant who intends to live in a home and  ‘occupy’ it themselves. This means that the owner does not intend to rent the home out or use it as an investment property initially, so the lender will not ask to see any rent receipts to prove that an income is being made from the property. Owner occupier loans can also be used to fund major renovations on a property that you live in, or for the purposes of financing and debt consolidation.

What is an investment home loan?

An investment loan is a type of home loan that you can take out in order to purchase an investment property. Investment loans can differ with terms, conditions and features. They often require a lower loan-to-value ratio, meaning you may need a larger deposit than you would for a standard home loan. Likewise, analysis of more than 4,000 home loan products on Canstar’s database has also shown that investment loans tend to have a higher interest rate than standard home loans.

What is a refinancing home loan?

Refinancing home loans are designed for holders of an existing mortgage who wish to switch to a different mortgage. There are a number of reasons you might choose to switch your mortgage. You may find that a different lender offers a lower interest rate, or a loan with more appealing features. Likewise, you might refinance if you wish to sell your home and move to a different one, if you wish to enlarge your loan to renovate your existing property, if you simply wish to consolidate debts, or if the loan you have has reached the end of its fixed term.

What is a reverse mortgage?

A reverse mortgage is a loan that is generally only available to borrowers aged 60 and over. This type of loan can allow you to convert a portion of the equity you have in your home into cash. It allows you to borrow against your usable equity, and is generally available either as a lump sum or a smaller recurring payment. The latter option is popular among retirees looking to boost their income.

Note that with a reverse mortgage, you will only be able to borrow a certain percentage of the value of your home, and generally speaking, the older you get, the higher this percentage becomes. With a reverse mortgage, you retain ownership of your home, and you can generally make repayments in part or in full at any time without incurring a penalty.

If you are considering a reverse mortgage, it is worth keeping in mind that over time your debt will grow and your equity in the property will decrease. You will still be able to leave your home as part of your inheritances, but any heirs will need to repay the loan balance. It is also important to note that a reverse mortgage often carries a higher interest rate than other types of loan.

If you are in the market for a home loan or even seeking to review your current one, you can compare over 3,000 mortgages from more than 80 lenders across Australia on Canstar’s database to find one that might be suitable for you.

 

Original reporting by TJ Ryan, additional reporting by Alasdair Duncan. Cover image source: Bmphotographer/Shutterstock.com


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