Which Home Loan Works for Me?

October 5, 2021
Housing Loan

You may have already found your dream home from browsing our search page. Or perhaps you’re still looking?

Either way, most home buyers will take out a home loan, especially if it’s their first time. Home loans today are more personalised than ever. You might want to pay a little less for a longer period of time, or on the contrary, pay more over a shorter timeframe. So the key here is to be honest about your circumstances and long-term goals.

Today, we’re diving into the different types of home loans available for first home buyers and exploring the pros and cons. After all, this is a big purchase, and we want to ensure you’re making the best decision for you.

1. Variable home loans

To start off, one of the most common loan schemes out there would be the variable home loans. In a nutshell, variable loans offered by the banks rely heavily on the interest rate set by the Reserve bank.

This interest rate can increase or decrease over time and is not fixed. Variable loans can therefore be seen as a double-edged sword with the possibilities of savings on your monthly repayments if interest rates decrease, or higher payments if interest rates were to increase.

Loans like these are able to provide additional benefits such as redrawing (withdrawing extra funds that you have deposited to offset your loan/interest payments) and honeymoon rates, but it exposes you to the risk of higher interest rates.

In short, advantages that variable home loans offer are

  • Repayments decrease when interest rates fall
  • Additional benefits such as the ability to make additional payments, such as a redraw facility, low introductory or honeymoon rates
  • Allows careful borrowers to pay off the mortgage quickly by not having any penalty for advance payouts

The disadvantages are that

  • Interest rates can be higher over time because they offer additional flexibility
  • Repayments increase when interest rates rise

In essence, variable home loans are great for buyers looking for flexibility. It’s best suited for disciplined borrowers who wants to pay off mortgage quickly by not having penalty for advance payouts.

However, one must be careful with financial budgeting for loan repayments and has to make sure that enough is allocated in case there is a scenario of an increase in interest rates.

2. Fixed home loans

The second most popular option among borrowers would be fixed home loans. As the name suggests, your interest rate will be fixed over a set period of time.

This can be a great alternative for people who want to have a locked in monthly repayment cost, since the repayment amount can be calculated at the very start.

Most of the terms last between one to five years and once you’ve locked in your fixed rate, you will start paying for the interest (and potentially principal repayments) right away.

For example, if a borrower fixed their loan today at a five-year fixed rate which is 2% higher than the variable interest rate, the borrower would be paying an extra 2% interest right away.

Once you reach the end of the fixed rate period, you can then decide whether to fix your loan again at the current market rates or convert the loan to a variable loan for the remaining time left of the loan.

The advantages are that

  • Provides a sense of security for borrowers who are concerned about rate fluctuations
  • Repayments do not rise if the official interest rate rises potentially saving you thousands of dollars

The disadvantages are

  • Repayments remain the same even if interest rates fall
  • Allows only limited additional payments and loan offset opportunities
  • Penalties on early pay-out of the loan within the fixed period you fixed
  • No additional features for your loan such as advance payments or redraw facilities

To sum it up, fixed home loans are great for people who seek precise budgeting since the interest that borrowers will be paying can be calculated from the very start.

They are also flexible with lock in periods that are typically short ranging from 1-5 years and borrowers can revisit their financial decision after the fixed rate period ends on whether a fixed loan is best suited for their needs.

3. Interest only loans

The third loan type on this list is the interest only loan. For this loan, it works by getting the borrower to only pay off the interest over a set period of time and not paying down your principal loan (i.e. the total loan that the bank is lending you).

For example, if a buyer sets the interest only period as five years, it would mean that the first five years are spent on paying interest and not paying down/reducing the principal loan itself.

After the set five years, the borrower would then start to repay the principal loan each month by paying “principal and interest” repayments over the remaining term of the loan.

The advantages are

  • Lower repayments to be made initially
  • Cuts the ongoing cost of taking on a home loan in the short-term, which could allow you to save money for other monthly costs you may have

The disadvantages are

  • Over the life of the loan, as you are not initially “paying down” your principal loan (i.e. the total amount you borrowed), this means that you are being charged interest on the full loan and thus the total costs of the loan will be greater
  • There will be a sudden increase in monthly repayments when Interest Only period ends since borrower would need to repay both the principal and interest
  • Whilst you may apply for an interest only loan, lenders will still assess your ability to repay the loan only on a combined principal and interest monthly repayments referred to as your capacity to “service your loan”.

In summary, interest only loans are good for buyers with plans to do use the short term cash savings for a renovation or property improvements since they will have more money at the start of the loan period.

Interest only loans are also favoured by investors who typically do not want to pay down their principal loans, as this would reduce their benefit of“negatively gearing” their investments, a topic that we will cover in detail in another article.

Investors are banking on the capital appreciation of the property so that they can keep their holding costs low and then reap the benefits of capital gains once they sell the property in the future, since they may not be planning to hold the property for 25-30 years or use the property as their own home.

4. Low doc loans

Low doc loans falls under a special category and are usually catered to investors or self employed/freelance borrowers where a bank may consider their incomes not to be as stable as someone who is employed by a non-related company.

This type of loan is generally perceived as higher risk by lenders since a more stable source of income for the borrower cannot be substantiated by conventional means.

As a result of these higher risks, low doc loans usually attract a higher than average interest rate and limitations in terms of loan flexibility.

In order to substantiate their proof of income, the borrower may have to provide supporting documents such as GST registration, past personal tax return history and Business Activity Statements etc.

The advantages of low doc loans are

  • Access to loan options that would not normally be approved for a loan due to being self-employed/a freelancer
  • Being able to use alternative documents and streams of income as support for the loan application

The disadvantages are

  • Higher interest rate compared to traditional loan schemes
  • Fewer features compared to normal loaning schemes
  • Not every bank or lender offers low doc loans as they may consider these loans too high risk

In summary, low doc loans are an option for freelancers or the self-employed looking to finance their next home.

However, proof of income has to be properly substantiated to reassure the lender that the loan can be “serviced”.

It is important that an income audit is to be done with an experienced mortgage broker to work out net income and the amount of loan one can afford realistically.

Doing so could open up the possibility of discovering more lenders and product choices that you may need.

5. Line of credit loans

The next loan type we will be sharing will be the line of credit loan, LOC for short. LOC is a special type of loan where it is dependent on the equity of your property. LOC are typically known as reverse mortgage.

Essentially, it allows you to unlock equity in say, a property you already own, for access to credit. It usually requires an interest-only payment as a minimum each month, which can add up to a lot of interest in the long run.

The advantages are

  • Ability to unlock equity via a reverse mortgage to use for say, a renovation, and then pay it back when you need
  • Interest rates tend to be lower than that of credit cards or personal loans as the loan is “secured” against an existing property you own

The disadvantages are

  • Since you are securing your loan against an existing property, should you “default” on your loan then your property may be sold in order for the lender to recover their initial loan to you
  • Reverse mortgages typically attract higher interest rates than other home loans
  • The need to be self disciplined to make principal payments on an asset that you may have not previously had to have made any payments on

Overall, a line of credit loan is catered towards people who already have equity on their property and are seeking to convert that equity to cash for funding their personal needs such as renovation or holidays.

The risk is that balance can be costly if the principal amount is not reduced since there is a high interest rate to be paid on a monthly basis.

Often you may find that a reverse mortgage is also popular with those approaching retirement, as it is a way for retirees to unlock wealth that they have built up over time via a family home that they own and once retired, they may not have a regular income to be approved for a loan in future.

Do take note that there’s no “one size fits all” home loan but this article should be able to give you a rough idea of the type of home loan that is suitable for you.

Financial appraisals are especially important when it comes to home loans as you’ll be able to understand your capabilities when it comes to borrowing and repaying.

That said, our best advice would be to consult a mortgage broker to do an appraisal and to find out more about the specific home loan schemes offered.

If you’re still looking for your dream home or inspirations, head on over to our search page, where you can browse and swipe thousands of property listings and real estate content. And make sure to read up on what to think about before buying your first home too. Happy hunting!

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