Purchasing a home is a big decision and not something many people do often, so there’s no surprise people get stumped when it comes to the jargon they hear around home lending. Guest blogger Kathryn Plevey, from Heritage Bank runs through some of the basics:
Think about your job – whether you’re a mechanic, builder, parent or nurse – you know your topic back to front. If you were learning a new area of expertise in your field you’d do the research and understand everything you can. Now, think about buying a home and the commitment you are signing up for– it’s one of the biggest purchases you will ever make. This means it’s probably a good idea to put some time aside to learn all you can, including getting your head around some of the confusing jargon.
When talking to your finance provider, or doing your own research, you’re likely to come across an array of interesting new jargon. To help you out, we’ve explained six of the most common confusing terms:
- Comparison rate
Whenever you see a home or personal loan rate advertised it will be accompanied by a comparison rate. In some advertising, you might only see the comparison rate. Many people think a comparison rate is used to show the price competitor lenders are offering. However, the comparison rate actually has nothing to do with competitors at all. The comparison rate is a Government requirement, and is designed to reflect the ‘true’ cost of a loan, factoring in any applicable fees, and taking into account the fact that a home loan might revert to a different rate after a certain period of time.
All home loan comparison rates are worked out based on a loan amount of $150,000 over 25 years, which means if you’re borrowing a different amount, or borrowing over a different period of time, the promoted comparison rate won’t apply to your circumstance. While it could be a good way to compare “apples for apples” generally, it is also important to take into account all features associated with a loan product and find out the exact rate you would be paying for your particular situation.
Example: Tim and Jane compare rates – what do they consider?
Tim and Jane are comparing home loan interest rates online and have narrowed their choice down to two lenders. Lender A is offering a loan with a comparison rate of 4.00%, while Lender B is offering a loan with a comparison rate of 4.25%. Before deciding Lender A is the best rate Tim and Jane consider any potential future costs associated with each loan product. This includes:
- Redraw fees
- Switching fees
- Break fees (for fixed rate loans)
Tim and Jane also want specific features such as an offset savings account attached to their mortgage. Not all loan products offer this feature (particularly really cheap ones) so it is important they find this out before making a decision.
Because different lenders offer a different mix of fees and interest based on loan term and loan amount, Tim and Jane decide they would like to make contact with each lender to find out how much their repayments will be depending on the actual amount they want to borrow and the period they want to borrow it for.
After meeting with each lender Tim and Jane are ready to consider both options before proceeding with their chosen home loan product.
- Variable rate
Home loan interest rates can go up or down depending on a number of economic factors. The most important influence is the lenders’ cost of funding – i.e. the amount the banks have to pay for the money they lend to you. One of the places banks get their money is the Reserve Bank of Australia (RBA), so when the RBA raises or lowers the cost of funding to banks (known as the “Cash Rate”), there is a flow-on effect on the amount you pay for your mortgage. The benefit of taking out a variable rate is that if interest rates go down you will pay less. However, if interest rates go up so will your payments.
- Fixed rate
If you take out a fixed rate loan you will know exactly what your repayments will be for the fixed period of the loan. Many people take out a fixed loan for certainty, which can work out well for them if rates do go up. People usually fix their loan for a period of 1-5 years. Once this time is up it might be a good idea to shop around for the best deal possible for you. This could mean moving your loan over to another lending provider. It is possible to split your loan between both a variable and a fixed rate. This is called a split loan.
- Lenders mortgage insurance – LMI
Lenders need to protect themselves in the unfortunate event that you might not be able to repay your loan. In the same way as you insure your house against loss via theft or damage, banks also insure their mortgages against people defaulting on repayments. In some circumstances, this cost is then passed on to the borrowers. How much lenders mortgage insurance (LMI) you pay will be determined by the amount you want to borrow. Generally, you will need to pay LMI if you borrow over 80% of the purchase price of your property (this percentage is also known as LVR – explained below in point 5). This will be discussed in your loan appointment – a great reason to consider visiting your credit provider or broker sooner rather than later.
- Loan to value ratio – LVR
Loan to value ratio (LVR) is the ratio of the loan amount against the value of the property you have secured. LVR is used for lenders to determine whether or not lenders mortgage insurance will need to be paid. As well as this, some lenders will offer special rates for customers depending on their LVR.
Example: Sarah and John find out their LVR
Sarah and John are purchasing a new home for $370,000 and will be using $60,000 in cash as a deposit. This means the actual mortgage the couple needs is $310,000. To find out their LVR Sarah and John need to divide the mortgage amount by the value of the property and then multiply this amount by 100. By doing this the couple have found out their LVR is 83%.
Because their LVR is above 80% Sarah and John will need to pay lenders mortgage insurance to their bank. This will be added onto the total of their mortgage.
- Offset account
An offset account is a savings account connected directly to your mortgage. Many mortgage lenders such as Heritage Bank offer offset accounts with their home loan products. The amount of money you keep in that account will be offset against your loan amount and will reduce the amount of interest you pay every month on your account. Not all loans (especially the really cheap ones) allow you to have an offset account attached to your loan. If you want an offset account make sure it’s a feature of the loan product you are taking out.
Example: Simon pays less interest on his home loan by using a mortgage offset account
Simon’s home loan balance is $320,000. He currently has $15,000 in his offset account. This means Simon is only paying interest on a home loan balance of $305,000. If needed, Simon is able to use the $15,000 at any time. However, by taking money out of his offset account this will directly affect the amount of interest he pays on his loan.
When it comes to buying a home there’s risk in being shy. It’s important you seek and question advice rather than go along with the flow. Arming yourself with knowledge will help to ensure you’re a confident buyer. If you’re a confident buyer then you’ll be happy knowing you made the right and best decision for yourself.