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Ben Kingsley Blog post by Ben Kingsley

Different Types of Property Loans and Why Interest Rate Is NOT King 

When purchasing a property in Australia, there are a number of mortgage loan options available. Each has its different benefits such as low interest rates or higher borrowing power, as examples some require principal and interest repayment while others offer interest only terms, while others allow for smaller payments. The best loan will depend on the needs of the individual as well as financial variables like credit, debt, deposit size, etc. Matching the right loan option should be a decision based on low flexibility, access, as well as cost (interest rates).

Before we look at the loan options, there are two categories of interest rates that we need to understand first.

 

A. Variable Rates 

The most common loan options in Australia is the variable loans. It has an interest rate that fluctuates over the course of repayment but its popularity is mainly due to the extra features available like waived application fees, the possibility of small minimum repayments and even the option to make additional repayments. The increases and decreases are primarily affected by the official cash rate, set by the Reserve Bank of Australia which in turn is determined by the current market movement and economic conditions. An interest rate rise can occur at any interval and at any point in time and as such these fluctuations do have an effect on your regular monthly payments on this loan.

There are two type of variable loans; standard and basic. The former allows more feature and benefits such as professional package options including property valuation, aggregated lending (interest rate discounts), free credit cards, offset accounts etc as extra repayment options, access to a line of credit and more while the latter offers just a simple loan set up with just extra repayment features, “No-Frills” as we like to call it.
Offset Account 

An offset account is a unique option for lowing the payable interest of a mortgage and is usually available for variable loans. It functions as a transaction account that is attached to the loan and provides extra liquidity to the borrower. The balance in this account is offset against the outstanding borrowed funds. So basically, since the interest amount is calculated on a daily basis, the more money and the longer the money stays in the offset account means the less interest that you need to pay. These can be great cushions for those who have variable rate terms. In the event of an interest rate rise, borrowers will have a sort of safety net so monthly payments remain manageable. Overall, this helps reduce the term of the loan in addition to saving tremendously on interest related fees and eliminates the need to make extra repayment or higher value repayments into the mortgage. 

 

B. Fixed Rate Financing 

Fixed rate financing implies that the interest rate remains stable throughout the life of the loan, but this is not the case. In fact, the rate is only fixed for a defined period in between one to fifteen years. Usually, the more popular choices for a fixed rate is three or five. While borrowers don’t benefit from the market’s decreased interest rates, they are immune to increases, which helps keep finances very steady. This is why you need to have a serious discussion with your mortgage broker on what they think of the prospect of the interest rate movement and whether it is a good time to fix. After the initial fixed payment time, lenders/mortgage brokers and borrowers can discuss the rate of the property loans and whether to confine as a fixed or variable mortgage.

 

Most loans are either a variable rate or a fixed rate and here are some brief descriptions on the common property loan types:

  • Split Rate Loan 

When learning how to buy a property, you will find that a split rate loan is a hybrid of the fixed rate and variable options. For this type of lending situation, the lent amount is split so one part is variable while the other is fixed. The structure allows for a balance of flexibility and stability.  In a way, you are getting the best of both world but be very diligent on the ratio of the split amount. Regular payments are reasonably dependable for this type of loan but at the same time, borrowers still benefit if interest rates fall. If it is desirable, the variable portion can be paid off first. For those who want a bit of everything, the split rate loan can be a good choice, and it can be a great way to “hedge” meaning – taking a measured guess on what will happen to rate during the fixed item you choose.

 

  • Line of Credit 

A line of credit or otherwise known as equity line, is best for those who want to maximize the use of their income and pay off their mortgage as quickly as possible if they didn’t opt for an offset account. Additionally, it is great for individuals who need high flexibility and constant access to cash flow. To repay the amount fast, some people have their salaries go straight into the account. As long as payments are kept regular, borrowers can withdraw from the credit line on a monthly basis. Experienced investors may notice an interest rate rise when using this option for the first time. It is standard for credit to carry slightly higher interest rates, but the access is a comparable trade-off.

Think of it as credit card. A loan facility secured by a home and is pre-approved up to a limit. Like a credit card, you only need to pay on your loan. They can be handy when you need to release equity to pay a deposit on investment property.

 

  • Introductory or Honeymoon Loan

The introductory or honeymoon loan was first designed for first home buyers or novice borrowers. What this loan offer is a discounted interest rate for the initial 6 to 12 months and some lenders will even extend it to a couple of years. However, once this promotional period ends, the rate will revert to a standard, which is usually some form of a variable percentage. On most occasion, this variable rate will be higher than then average market rate.

In effect it “supposedly” helps the borrower which lower interest repayments when they are starting out but often, post the honeymoon period, the lender re-coups more returns with the rate go higher.

 

  • Interest Only 

As the name suggest, this option allows the borrower to pay only the interest without the need to pay down the principal amount. It is easiest to think of interest only property loans in two parts. The first phase will last anywhere from one to ten years. During this beginning period, the borrower will only pay the interest due on the lent amount. This can be a great benefit for those who want to invest, renovate or for someone who is a bit tight on cash flow for the initial period. However you will still need to pay down the principal amount at some point of time. Following this low cost time frame, the repayments will include both principal and interest much like a normal loan pay plan. In most case, it can be applied to both variable and fixed loan types. 

 

Interest Rate Is Not King 

Why aren’t interest rates king? Don’t get us wrong. We absolutely think interest rate is important because you do not want to pay an additional $50 a month when you can get a better option elsewhere. Having said that, what is more important is structure and finding the right package that fits the borrower’s money management style. If you keep chasing interest rate you might be blinded with how inflexible the loan is and whether it will provide you with the additional features that will contribute to your cash flow position, or your future plans.

A mortgage/home loan should be made to fit your current lifestyle and what you intend to do in the future. For example, if you are thinking of starting a family or if want to renovate the property before moving in, you will need to have a higher liquidity. On the other hand if you are not thinking of doing anything in the short run but you are planning to buy the next property in future, your loan might need to be set up in preparation for that purchase.

It comes as no surprise that a lot of people that we’ve met with are unaware that good money management skills plays a part in choosing your loan. Good money management skills are when you are aware of your household’s cash flow position and all your assets and liabilities. Ideally, you want to keep your loans fairly simple and easy to manage. If a lender or a mortgage broker tells you that you can get 0.05% lower in interest rates but you need to cross securitise your home with a whole load of other assets, you need to consider if it is worth it. You don’t want it to be overly complicated especially if you have multiple loans.

The other “hidden warning” is a lender might offer a really cheap interest rate today to sign you up, but then at their discretion put the interest rate up without warning (Yes, they have this power without their loan contracts).

All in all, do remember that there are still other loan options that are not mentioned here so, always seek professional help when setting up your loan.

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