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How home loans work
A ‘home loan’ or ‘mortgage’ is a sum of money loaned to you by a financial institution so you can buy a property. In return, the lender uses the property you buy as security for the loan. That means if you fail to make your loan repayments, the lender may sell the property to settle your debt.
When deciding which loan is right for you, consider the type of loan or features you need, the interest rates and fees.
Types of home loans
Variable rate loan
If your loan has a variable interest rate, the repayments will change when the lender adjusts its rate – for example, when the Reserve Bank of Australia lowers or raises the cash rate and your lender follows suit.
A variable rate loan allows you to pay off your loan early without paying a penalty. You can also transfer your loan to another lender without loan-break costs. If your variable interest rate falls your repayments will fall. The downside is that if your variable rate goes up, so will your minimum repayments.
Fixed rate loan
This means your regular repayments are ‘fixed’ for the period of the fixed rate home loan, regardless of changes in the economy and cash rate and your repayments remain the same for the term. Generally, you can fix these types of loans for up to five years.
At the end of the fixed term you can arrange another fixed term or move to a variable loan. Fixed rate loans are generally less flexible than variable rate loans, and you may incur fees if you make extra repayments, change lenders or pay off your home loan during the fixed term.
Split loans
If you like the certainty of a fixed interest rate but want the flexibility that comes with a variable rate loan, you can generally incorporate both options with a split home loan. You could pay off part of your loan sooner while also having some protection against rate increases.
Interest-only loans
These loans can appeal to property investors, as the interest paid can be a tax deduction. This means your repayments only cover the interest on the loan without reducing the principal, meaning, the original amount you borrowed will not reduce over time. Additionally, if the value of the home doesn’t increase, or decreases, you run the risk that you won’t build any equity in your home despite making monthly payments.
Interest rate versus the comparison rate
You may notice two home loan rates displayed – the interest rate and comparison rate.The interest rate is the annual interest cost for borrowing money, but it doesn’t take into account any fees. The comparison rate incorporates the annual interest rate as well as most upfront and ongoing fees.The comparison rate is calculated based on a $150,000 principal and interest loan over a 25-year term, so you can compare across providers but it’s not necessarily an accurate rate for your circumstances. Do your research and speak to lenders to see if you can get a better rate.
Understanding fees and charges
When comparing home loans, understand the various fees lenders may charge. Here are some to look out for:
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Fee type
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Description
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Application/establishment fee
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A one-off fee charged by your lender for setting up your home loan, if this fee isn’t charged, check if you’re paying higher ongoing fees instead.
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Ongoing fees
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Also known as administration or service fees, these are charged every month or year for administrating your loan.
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Redraw fee
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Some loans provide redraw facilities which allow you to ‘redraw’ any extra repayments you’ve made above the minimum. However, fees can vary from lender to lender.
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Fixed rate ‘break’ fee
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If you break your fixed rate home loan, you may have to pay a ‘break fee’. This can be significant, so be sure to speak to your lender to find out.
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Early exit fee
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Also referred to as an early termination, deferred establishment, deferred application or early discharge fee, you may have to pay this fee if you pay out your home loan in full within a set period of time (e.g. five years). Note that exit fees were banned on new loans from 1 July 2011.
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Discharge fee
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This fee may be charged when you pay out your home loan in full or are refinancing to another lender.
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Settlement fee
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This fee is the amount you pay your lender for their work regarding the settlement. Some lenders charge a fixed fee, while others charge based on the value of the transaction.
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Home loan pre-approval
When house hunting, you can apply for a home loan ‘pre-approval’ (or ‘conditional’ approval) from your bank so you know how much you can borrow. This can help to narrow your search and give you some peace of mind.
The lender will assess your financials, and while getting pre-approval can be a useful step, it is not a guarantee that your home loan application will be approved. They are a guide that your application fits the lender’s criteria, however it’s important to get full, unconditional approval before finalising a property purchase.
©AWM Services Pty Ltd. Current as at July 2023
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