How to choose the Right Mortgage
Article: Santosh Dhakal from AH Jackson & CO Chartered Accountants
1. What are the factors to be consider for Choosing Mortgages.
When choosing a home loan, it’s important to work out the features you need from your loan and how much it will cost you in fees. Generally following factors are to be considered on deciding the type of loan:
- Interest Rate;
- Repayment type;
- Repayment amount;
- Fees and Charge
The best way to compare home loans is to ask for a key facts sheet from different lenders. The key facts sheet will give you the information you need, in a set format so you can directly compare features, interest rates and fees.
2. What is Principal and interest loans means
In Principal and interest home loan, you make regular payments against the principal (the amount borrowed) as well as paying interest. This type of loan is designed to be repaid in full over the life of the loan, such as 25 or 30 years
A credit provider usually offer a range of features such as a redraw facility or an offset account. Generally the more features a loan has the higher the cost will be.
3. What does “Interest Only” Mortgages means?
Interest-only home loan is a type of loan where your repayments only cover the interest on the amount you have borrowed, during the interest-only period. There is no reduction in the principal.
This type of home loan will have lower repayments in the short term and may provide greater tax deductions on an investment property, but will be more expensive in the long run.
4. How do interest-only loans work?
With an interest-only loan, you only pay the interest on the amount you have borrowed.
These loans are usually for a set period (for example, 5 years) after which the loan changes to a principal and interest loan. Interest rates on interest-only loans are often higher than for standard principal and interest loans.
Before deciding taking out an interest-only home loan, you should work out how much the repayment will be at the end of the interest-only period to make sure you can afford the increased amount.
5. Risks: Interest-only home loans
Interest-only home loans seem more affordable because initially the repayments are lower than the repayments on principal and interest loans, but they have some drawbacks.
- Interest-only loans cost more– The amount of money you owe does not reduce during the interest-only period, which means you’ll pay a lot more interest over the life of the loan, compared to a principal and interest loan. For example, a $500,000 loan over 25 years, with an interest rate of 5%, would cost you an extra $40,062 in interest if it was interest-only for the first 5 years.
- Repayments will increase at the end of the interest-only period– When the interest-only period ends you’ll need to start repaying the principal as well as the interest – and, with less time to pay it off, your repayments are likely to be a lot higher.
- Not building equity– If your property does not increase in value during the interest-only period, you risk having no equity in your home at the end of this period, despite making payments every month. This may put you at greater risk if there is a downturn in the market or your circumstances change and you have to sell.
6. Benefits: interest-only home loans
Interest-only home loans can provide some short-term benefits, including:
- Lower repayments at the start of the loan– This may help you maximise the amount of money you can borrow or give you the opportunity to pay off other high-interest debt.
- Maximum tax deductions– Investors sometimes choose an interest-only loan to increase their tax deductions, which reduces their tax payable.
- Management of short-term lending needs– These loans are useful for transitional borrowing needs, such as bridging or construction loans.
7. How to manage when an interest-only loan changes to a principal and interest loan
Interest-only loans usually have a set interest-only period, after which the loan becomes a standard principal and interest loan. When the loan switches over, you will have to start repaying the principal as well as the interest, which can greatly increase your loan repayments. Some tips to help make the transition easier.
- Gradual loan repayment increase
If your loan allows you to make extra repayments, you may find it easier to increase your repayments gradually in the lead up to the switch to principal and interest.
For example, if your loan repayments will increase by $1,300 a month, you could increase your repayment by $100 a month in the 13 months before the switch.
- Loan repayment increase fast approaching
If your mortgage repayment is about to increase significantly and you’re worried you can’t afford the new repayments, here are some things you can do:
Re-do your budget – Reviewing your budget may help you find savings elsewhere that could soften the blow.
Ask for a reduction in your interest rate – Use a comparison website to see what loans are available from different credit providers and ask your lender to match a lower rate for a similar product.
Refinance your loan – If your lender won’t offer you a better deal you might consider switching home loans. Be aware that switching home loans could extend the life of your loan and/or you may have to pay lender’s mortgage insurance (LMI) again, which could cost you more in the long run.
- What if you can’t afford your increased loan repayments?
If your interest-only loan has already changed to principal and interest and you can’t afford the repayments, contact your lender immediately to negotiate a repayment plan. Here are some options you can ask for:
- Extend your loan period, so you make smaller repayments over a longer time
- Postpone your repayments for an agreed period
- Extend your loan period AND postpone your repayments for an agreed period.
When negotiating a repayment plan, make sure you can afford it. There is no point agreeing to an amount that is unaffordable
8. Redraw, offset and line of credit
- Offset account
This is a savings or transaction account linked to your home loan. Your account balance is taken off the amount you owe on your home loan, reducing the amount of interest you pay. You can use an offset account for savings or as an everyday transaction account.
For example, if you have a home loan of $500,000 and a balance of $20,000 in your offset account, you only pay interest on $480,000.
If the balance of your offset account is low, the additional costs may outweigh any benefits you get from having it. Be realistic when calculating the expected benefit an offset account may give you.
- Redraw facility
Having a redraw facility allows you to pay extra money into your loan that you can take out (or redraw) later if you need it.
The extra money you pay into the loan reduces your loan balance which reduces the interest you pay. Your loan balance will still reduce each month according to the terms of your loan.
Credit providers may impose conditions or a fee to redraw funds. You should check what conditions and charges apply to your loan.
- Line of credit loans
A line of credit is a loan where a credit limit is set and you can spend up to that credit limit.
The limit on the line of credit is fixed and does not reduce as you repay the loan. This means you can always draw up to this limit. You will need to repay the loan in full eventually, usually by a specified date, which you will need to plan for.
- Extra features can mean extra costs
Features like redraw, offset and line of credit can be useful but they may come at a cost. Loans with these features may have a higher interest rate or a product fee, so think carefully about which features you really need.
9. Bridging loans, loans for building and renovating
- Bridging loans
Bridging loans may be used to manage the transition between buying and selling properties. These are used by people who buy a new home before selling their existing home or who are building a new home. There are typically two types of bridging loans.
Offer a single loan taking both properties as security – They will then give you a bridging period (6-12 months) in which to sell your existing property. Generally you will only have to make interest payments during this period. Once the first home is sold, the proceeds are put towards your overall debt and the balance (end debt) will either revert to principal and interest repayments or you will have to enter into a new loan.
Offer a separate loan for the property being purchased – You will not need to make repayments on this loan during the bridging period. Interest will accrue on the new loan and you will still need to make your normal repayments on your existing home loan. When your existing home is sold and the original home loan is paid out, the outstanding debt on the new property will need to be renegotiated.
If you don’t sell your existing home within the bridging period, you may have to accept a price lower than you expected, leaving you with a larger end debt to repay.
- Loans for building (construction loans)
If you are building a new home, you may need a ‘construction loan’. With this type of loan you withdraw funds in stages, as you receive bills from trades people and suppliers. You’ll only pay interest on the funds you’ve used.
Most lenders offer their construction loans at a variable interest rate. Once the construction is finished, the loan will revert to principal and interest repayments.
Approval for a construction loan often requires plans, permits and a fixed-price building contract.