As a first home buyer, should you opt for the security and stability of a fixed home loan - or does a flexible variable product make more sense? Your Mortgage presents your guide on how to choose the right loan for you
Sourcing the best mortgage involves more than simply looking for a cheap rate - there are other important factors you need to consider, including the ongoing fees and charges payable, the loan's flexibility, and service on behalf of the lender.
Comparison rates were introduced to help borrowers understand the true cost of a loan, once all of the miscellaneous expenses and fees have been accounted for, but other features are not as easy to ascertain.
"Sometimes you will be attracted by a low interest rate, but it's important to make sure that the loan has the features you need," explains Lisa Montgomery, Head of Marketing and Consumer Advocacy at Resi Home Loans.
"Because first home buyers might not have the luxury of experience, they often don't understand that what suits them now and what will suit them in five years time can be totally different. It's really important to understand all of the characteristics of the loan, so you can determine how that will work for you in the future."
Types of loans
Standard Variable: Mortgage products that generally carry flexible features such as redraw, offset and the ability to make extra repayments
Basic Variable: A type of variable loan but typical strip of bells and whistles and it comes with a lower interest rate compared to standard variable loan
Introductory: Also known as 'honeymoon' loan, this product offer a discounted rate often as a variable loan during a certain period. After the introductory period ends, the interest rate reverts to a higher rate, often to the lender's standard variable rate.
Fixed: This product carries a fixed rate for a certain period usually 1 year, 2 years up to 5 years. After the fixed term, the interest rate reverts to the lender's standard variable rate
Equity/Line of credit: This type of loan allows the borrower to draw out money up to a specified limit, using the equity in their property. Interest rates are generally higher compared to standard variable loan. This product is more suitable for existing property owners as it requires equity in the property.
Interest only: Not technically a loan type, but a method of repaying your loan where you only have to repay the interest component of the loan, not the principal. These loans are generally offered for up to 10 years before they revert to a Standard Variable product
Now that you know what each loan offers, how do you decide which loan is right for you?
These are "probably the most popular" mortgage on the market, Montgomery says.
"It's like the cheeseburger of the loan world," she explains. "Effectively, it's the most popular loan that all home buyers will look to take up, because it's easy to compare in terms of rates, and it comes with all of the bells and whistles that you can imagine."
Those "bells and whistles" can include offset accounts - where you place any savings in an account that is linked to your loan, to "offset" the amount of interest you pay. If used properly, this facility can help you reduce the interest you pay and shorten the loan term. You would need to keep a substantial amount in the offset account to make it beneficial.
At the very least, standard variable loans allow you to make extra repayments and offer redraw facility.
Standard variable loans generally track the rate movement of the Reserve Bank of Australia. This means when the RBA cuts rate, lenders tend to cut by the same amount as well. However, since the start of the global credit crisis, lenders have been raising and cutting rates independently of the RBA.
Standard variable mortgages are ideal for all borrowers and first home buyers can greatly benefit from its flexible features, however, they can be more expensive than the basic variable loans.
Basic variable loans carry cheap rates and work the same way as a standard loan, but without the extras.
"Often you'll find they have a lower interest rate, but that comes with a reduction in flexibility," Montgomery says.
While the rates and fees are some of the lowest in the market, most basic variable loans do not provide consumers the same flexibility as their fully-featured counterpart - the standard variable loan.
With a basic variable mortgage, you may not be allowed to make extra repayments and have access to that fund later. Some lenders may impose a penalty for paying extra as well as other restrictions.
"It's because it has these characteristics and is missing these extra features, that it has the lower rate," Montgomery says.
"You need to get a good feel for that, because your loan as a package needs to address the interest rate, fees, flexibility and service. You need to know which features are important to you in order for you to operate the loan and manage it."
If you're looking for a cheap loan and don't need all the extras then basic variable loan can be an economical way to pay for your property purchase.
Intro or honeymoon rate
Intro rate loans - often known as honeymoon rates - offer a reduced interest rate for a set period of time, usually one to three years.
Interest rates on introductory loans are typically lower by around 1% compared to the lender's standard variable rate. However, there is a caveat: when the intro period ends, it reverts to the standard variable rate.
So while you might secure a 6.2% interest rate for 12 months, the loan might then revert to standard variable rate of 7.6%, when other standard variable customers are accessing a rate of 7.3%.
"You need to be aware of what the intro rate is going to roll up to, because you need to make sure that rate is competitive," Montgomery says.
"You should also ask whether you can make extra repayments throughout that introductory period, because you want the opportunity to pay as much off that loan as you can from day one. That will really get you ahead in those first few years."
Intro rate loans will benefit those first homebuyers who needed a breathing space while getting used to having a mortgage because loan repayments are cheaper during the introductory period. The money you save during this time can be used to furnish your new home or fund your renovation.
When considering an intro loan, make sure that the revert rate - the rate to which the loan returns to after the intro period - is not too high that it wipes out any savings made during the introductory period. You need to be aware that this revert rate is what you'll be stuck with for the years to come.
The duration of the intro period is also important - obviously the longer the intro period, the better. Exit fees can be massive if you want to pay off the loan within four years, so beware of these costs when making your decision.
In an uncertain rate environment, fixed rate loans offer some certainty and comfort, which can be appealing to new homeowners who are taking on the largest debt of their lifetime.
Fixed rate has a number of advantages for a first homebuyer. These include an interest saving if rates increase during the fixed term of the loan and the knowledge that your monthly repayments will remain the same.
With this certainty, it's easier to budget for the medium to long term. If you fix your loan at the bottom of the market - where we could be heading to very shortly - you can reap the benefit of a secure and low rate when the rest of the market bears the risks of higher interest rates. On the other hand if interest rates fall, you are stuck with the higher fixed rate.
At the moment, fixed rate loans are around 0.5% to 1% lower than their standard variable rate counterparts, so as well as locking in certainty, first time borrowers opting for a fixed rate can lock in a lower interest rate.
The key disadvantage of fixed rate loan is that once you're locked into one, it can be quite expensive to get out. If you picked the wrong time to fix, you can end up paying more interest rate than you would otherwise with standard variable rate. Fixed rates also are devoid of features that enable you pay off your mortgage faster.
"The thing to remember with a fixed rate is that you are quite restricted and often can't make extra repayments - you're really in a position where you've made a choice, and you're going to be stuck with it," Montgomery says.
Fixed rate mortgages will appeal to any borrowers who seek a stable interest rate and the peace of mind that their monthly outgoings won't change, regardless of what the economy is doing. Montgomery warns you to think long and hard before you opt to fix your loan, as hefty exit fees will usually be enforced if you wish the break your loan contract down the track.
Equity/Line of credit
More popularly know as a line of credit, equity loans enable you to access any home equity you've built up in your property. It's mostly used by people who have already owned a property.
Equity loans "are really for those more seasoned borrowers", Montgomery says. These products do not have a specific loan term and often referred to as an "evergreen" loan because you never have to pay it back within a certain period.
"You really have to have an intimate understanding of how the mortgage works, and the discipline that is required, to make this work," Montgomery says.
"You need to be putting all of your income into the loan, and all of your expenses on your credit card, which is 'swept' at the end of the month to reduce the balance to zero. If you're not disciplined, you could easily find yourself spending more than you should."
As a first home buyer, Montgomery says you would be better off avoiding this loan structure, and instead "edge in with a standard loan and a monthly repayment system - at least until you've explored all your options".
Interest only loans mean just that - you repay only the interest charged on the loan. Borrowers are permitted to make additional repayments off the principal of the loan if they wish, but it is not mandatory. Generally, these types of loans appeal to investors more than owner-occupiers.
"Interest only loans are often chosen by first home buyers because they are one of the lower cost options," Montgomery explains.
"If, for financial reasons, you wish to take out an interest only - because a principal and interest loan will push your budget - then I don't think you should really be getting the loan at all."
This is because you're not paying anything off the principal of the loan, so you're not creating any equity in the property. If you get an interest only loan for $300,000, three years later, your loan balance will still be $300,000, unless you've made any additional payments off the loan.
"Aside from the fact that purchasing your own home is the great Australian dream, the main reason why people venture into this form of asset is that you're going to start creating equity, which is going to create options for you down the track, "Montgomery says.
"That's really what you want, because then it sets you up to go and purchase another asset. Wealth creation is the primary focus - and interest only loans go against that philosophy."
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