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(1) Note: One thing to watch out for when a cheque book is attached to an account is that all withdrawals on the account will then attract Debits Tax (depending on your state/territory). If a split facility is available, use a separate split within the overall facility just for cheque book transactions. |
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There are a variety of home loan options available today. This article explains the features and advantages/disadvantages of the main categories of home loans.
The information in this article is also relevant for those wishing to structure their loan(s) in order to clear their mortgage in the shortest possible time-frame. If that is your goal, this article should be read in conjunction with our article: Mortgage Reduction Tips.
If you are looking to obtain a home loan for either an owner occupied or investment property, or if you are looking to refinance/restructure your existing lending, please see our page Save On Your Mortgage Payments for an I Hate Banks.com.au recommended mortgage broker (Australia wide).
This article comprises several sections:
The interest rate on a variable rate loan will vary over the life of the loan in line with the Reserve Bank of Australia’s (RBA) official cash rate, albeit that the rate on the loan will be higher than the RBA’s official rate.
Most of these loans are principal and interest (P&I) loans with a term of up to 30yrs, however one can get interest only variable rate loans. These loans generally fall into three categories.
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Honeymoon Rate variable loans are designed for first home buyers. They provide a discounted fixed rate for the first year, maybe 1% less than the Standard Variable rate, but then revert to the standard variable rate after the first year. The disadvantage with this type of loan is that you are generally locked into keeping the loan for a minimum 3yr period and penalties apply if you wish to refinance or payoff the facility before this period. Honeymoon Rate loans can be linked to Interest Saver/Offset accounts for Mortgage Reduction purposes.
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A Basic Variable home loan has the lowest ongoing rate of interest but has few options compared with a Standard Variable loan.
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A Standard Variable home loan has a slightly higher interest rate than a Basic Variable, but has more options such as allowing higher repayments to be made with the benefit of a redraw facility should one wish to later draw back out those extra payments, and the flexibility of having a linked Interest Saver/Offset account.
INTEREST SAVER/100% OFFSET ACCOUNT
This is typically an every day transaction type account whereby the interest paid to the account is used to reduce the amount of interest calculated on the associated home loan. Generally you would have all your salary paid into this account, as well as hold all your savings within it, in order to reduce the balance upon which interest is charged on your mortgage loan.
Because interest is calculated daily in most cases, you save interest every day with every dollar in your offset account. This is a very effective tool for Mortgage Reduction and can help you cut years off your loan.
However, a word of warning is required. Ensure that the offset account you choose pays the same interest rate as the rate on your home loan. Some banks are very tricky. They may label their product "100% Offset", and technically they will indeed be using the interest on 100% of the offset account balance to reduce interest on the home loan, only they will use a lower rate of interest on the offset account. It’s worth doing your homework on this one – getting the right kind of offset account could save you years on your home loan compared to the wrong type.
Whereas Variable Rates are pegged to the RBA's official cash rate, the key market indicator determining Fixed Rates are bond yields.
A Fixed Rate loan typically allows one the ability to lock in the interest rate for a period of 1 to 10 years on a principal and interest (P&I) basis, or for 1 to 5 years for an interest only facility. The interest only loan is often chosen for investment property purchases as any principal payment on the loan is non tax deductible whereas all interest payments are deductible.
The advantages are:
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these loans allow you to more accurately plan your finances as you know what your repayments will be for the life of the fixed term; and
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you are protected from interest rate rises during the life of the fixed term
The disadvantages are:
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the fixed rate is often (but not always) higher than the Basic Variable rate as you are paying a premium for the protection against a rate rise
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if official interest rates fall, you will be stuck with paying a significantly higher rate than that which you would under a variable rate
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you are generally not able to make additional repayments over and above the set repayment without incurring penalties
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they typically do not have the flexibility of an offset account or redraw facility as you would with a Standard Variable Rate loan
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you may incur a substantial penalty if you wish to refinance or sell your property prior to the end of the fixed rate period (this writer was quoted a penalty of $15K on a property he owns)
If the advantages appeal to you but you are put off by the disadvantages, consider a combination loan.
These loans allow for a percentage of the loan to remain on a variable rate, whilst the remaining portion of the loan is on a 1 to 5 year fixed rate. The borrower can nominate the percentage split they want, say 50:50, 60:40, 80:20.
This allows some protection against rising interest rates, but also for extra repayments to be made off the variable portion of the loan without incurring the penalty fees which normally exist when such payments are made on a fixed rate loan. Depending on the provider, one needs to watch out that one is not charged two sets of establishment and ongoing fees. A line of credit facility can also be accommodated onto this type of loan depending on the provider.
HOME EQUITY LOAN / LINE OF CREDIT
A Home Equity Loan, also known as a Line of Credit, is a transaction account secured by a mortgage over residential property with the applicable interest rate set a little higher than that of a Standard Variable home loan. There is no term to Home Equity loans, but typically a minimum monthly payment is due on the outstanding balance (at least equal to the interest which has been charged for the month). In some cases the interest can be capitalised (added to the loan balance) up to the loan limit without a minimum monthly payment being required. The credit limit is typically up to 80% of the value of the property (up to 90% with lenders mortgage insurance), and the funds can be used for any purpose: personal, investment or business.
Depending on the provider, the facility should be able to be split into multiple accounts, with separate cheque books and statements. For example, you could have one split for your home loan, another to finance the equity portion (20%) of an investment property, another for share purchases, and yet another for discretionary spending. This facilitates the calculation of tax deductible interest amounts (for the investment property and shares) as opposed to the non-deductible amounts (home loan & discretionary spending).
All of your income can be credited directly to your Home Equity loan, and this enables you to close all of your other existing bank accounts to save on fees. It can be used in the same way as a standard transaction account, with ATM and EFTPOS access, as well as a cheque(1) book, and an attached debit card. As an alternative to a debit card, you can obtain a 55 day interest free credit card and set it up so that the outstanding card balance automatically transfers to the loan at the end of the interest free period.
If managed properly, these are very effective accounts for Mortgage Reduction strategies and can cut years off your home loan. Interest is only charged on the daily outstanding balance, hence the common practice of crediting all of one’s income directly to the account to reduce the daily balance upon which interest is calculated. Living expenses can then be paid for out of available funds within the loan on a needs be basis. For example, one might pay all of one’s monthly expenses with a 55 day interest free credit card and pay off the entire balance of the card on the due date using funds from the Home Equity loan account.
Depending on the provider, other advantages include:
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it’s portability, allowing you to transfer your loan from your existing property to a new home. This saves the hassle of refinancing, and saves money on stamp duty and loan establishment costs, although some charges will apply for the bank to administer the transfer;
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any amount of principal and interest can be paid off the loan at anytime without charges;
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a cheque book and credit card can be attached to the loan
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if you lose your job, you only have to meet the interest payments
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there is generally no minimum withdrawal amount. This allows for small amounts of cash to be withdrawn via ATM whenever needed
This type of facility can also allow one to consolidate existing personal loans or credit cards into the Home Equity loan, thus saving money by virtue of the lower interest rate on the loan.
Such great flexibility has its pitfalls. One of these is that if you use a Home Equity loan partially for investment purposes and the investment goes awry affecting your ability to service the debt, you could be putting your house on the line. Similarly, if you use it to buy the family car and you become unable to service the facility due to illness or job loss or rising interest rates, it will no longer be the car your banker will come to repossess but your house.
Whilst Home Equity loans can provide disciplined borrowers with the advantage of a vast degree of flexibility in managing their finances, undisciplined borrowers who go out and spend up on depreciating items (car, boat, widescreen TV) can find themselves in a never ending debt trap. In the past, home owners would pay their mortgage off as soon as possible. Now they can have a new car, or a holiday, etc… and for those who succumb to this temptation, the flip side is that they are likely to find a mortgage remaining on their home even at the age of retirement.
For a generation that is likely to see the phasing out of the old age pension, this wouldn’t be a pretty prospect.
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Before applying for a loan, get the financier/broker to organise a letter which includes all of the conditions which you were told the loan would satisfy. Terms and conditions can change frequently, and the person you spoke to may not be entirely familiar with all of the fine print in your loan contract. This writer negotiated a 5yr fixed rate loan back in 2000 with the option, but not the obligation, to decide in June of each year to either make interest payments a year in advance or simply make the monthly loan payments as they fell due. A year later, after I decided to exercise the option of pre-paying a year in advance, I was told I couldn’t do it. Fortunately, I had got it in writing, and the financier was obliged to honour their promise.
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Cheque books: Debits Tax is, in most states, charged for withdrawals on accounts with attached cheque books. The problem is, you are charged the tax on all withdrawals simply because there is a cheque book attached, even if the withdrawal itself was not done using a cheque. To minimise the cost of debits tax, only attach a cheque book to those account splits where you actually need a cheque book. Debits tax can therefore, in most states, be entirely avoided on accounts if no cheque book is attached.
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Interest Rates: One must be aware that a "low" interest rate is not necessarily the cheapest. You need to take into account 2 things besides the restrictions on a "cheap" rate:
What fees are applied to the loan
Is the interest calculated daily and charged at the end of the month? This is called "monthly in arrears" and is the standard practice adopted. However, some lenders may offer a really cheap rate but be charging the interest daily, or at least calculating it on the daily balance plus the interest already accrued so far that month. This is a daily "compound interest" calculation and is a big no no. It will cost you $000’s if they are calculating it this way so it is worth checking it out first.
Make a list of all the features that you need for your loan and assign a priority ranking to each. Then go out and do your research with different lenders and use a comparison checksheet to mark those features which are most important to you. If you find you don’t need the bells and whistles available on a Standard Variable, then switch to a Basic Variable with a lower interest rate, maybe up to 1% cheaper.
If you are looking to obtain a home loan for either an owner occupied or investment property, or if you are looking to refinance/restructure your existing lending, please see our page Save On Your Mortgage Payments for an I Hate Banks.com.au recommended mortgage broker (Australia wide).
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