Article by Mozo
If you are one of the many first home buyers out there struggling to save up that ideal 20% deposit, you might be happy to hear you can get in earlier with just a 5% deposit. But before you think “where do I apply?”, we should mention there’s a price to pay and it’s called lenders mortgage insurance.
It’s an insurance banks and financial providers in Australia take out to ensure they are not out of pocket if you fail to repay your home loan. The reason only low deposit loans of less than 20% require lenders mortgage insurance is because you are borrowing a large amount of the value of the property and are considered a more risky borrower.
Keep in mind, lenders mortgage insurance is only designed to protect the lender, not the borrower. So if you wanted insurance to cover your repayments because of illness or injury, then you’d need to look at taking out mortgage protection insurance.
No the lender will organise this on your behalf, as each home loan provider will have their own insurance provider they use.
The cost of lenders mortgage insurance will depend on the amount you are looking at borrowing and the deposit you have saved. There’s no one size fits all equation you can use to determine the cost of LMI, as it will differ depending on the bank you borrow from and the insurance provider the lender uses.
However, using one of the major LMI underwriters in Australia Glenworth’s LMI Premium Estimator we can get a rough idea of the lenders mortgage insurance cost depending on varying scenarios.
Scenario 1 - Peter has found a great investment studio that is bargain priced at just $200,000.
Lenders mortgage insurance
Scenario 2 - First home buyer Jen is looking at purchasing her first home worth $500,000.
Lenders mortgage insurance
Scenario 3 - Newlyweds Nathan and Samantha are on the hunt for their first family home and have a budget of $800,000.
Lenders mortgage insurance
* Prices taken on 13 July 2015 for a home loan period of up to 30 years
As you can see in each scenario above the difference between a 5% and 10% deposit is almost double. That’s why it always pays to diligently save the largest deposit you can to bring down the cost of lenders mortgage insurance.
LMI is an upfront cost that you can either decide to pay upfront or add to your home loan. However, keep in mind putting the cost of LMI on your home loan will increase the amount of interest you pay over the life of the loan.
For instance, take Nathan and Samantha’s scenario from the above tables. If they take out a home loan of $740,000 ($800,000 - $40,000 deposit) with a 5% interest rate, that $33,820 lenders mortgage insurance will end up costing them $25,492 extra in interest over a 25 year period. It might not sound like much, but that’s a total of $59,312 LMI will set them back - enough to fund a brand new family car or home reno!
If your loan to value ratio is above 80% then, yes unfortunately you will have to fork out the cost of lenders mortgage insurance, as it is not transferrable. That’s why it’s better to wait until your property has appreciated in value and you’ve paid off enough of the principal until you switch lenders.
There are two main ways you can skip paying LMI. The first and the more obvious option is to continue to save until you have at least a 20% deposit and the second move is to ask your parents or another family member to be a guarantor for your loan, using a portion of their own property as security for your home loan.
As you can see the cost of lenders mortgage insurance is pricey that’s why it pays to do your homework and compare the home loan market for a competitive mortgage deal that will allow you to reduce the cost of LMI in the long run. Start by considering what type of interest rate you’ll go for:
Fixed interest rate: While a fixed rate is great if you want to know what your ongoing repayments will be and don’t want to worry about rate changes for the first few years of your home loan, keep in mind that many fixed rate loans are not as flexible as the variable rate alternative and may not come with options like a 100% offset account. There’s also another major downside of a fixed rate loan, which is after the fixed rate period finishes it will usually revert to a less competitive variable rate. While you might be thinking “I’ll just switch to a better deal”, refinancing may not be worth it because as mentioned earlier in this guide unless you have paid off over 20% of the property value you’ll have to pay lenders mortgage insurance again, which could defeat the savings made by switching.
Variable interest rate: The same applies for a variable interest rate, as you’ll need at least an 80% loan to value ratio to make switching home loans worth it but the major drawcard of a variable rate loan is most come with some great features which will help you pay down your loan earlier and reduce the cost of lenders mortgage insurance in the long run. Some of the common features you’ll find with a variable home loan is unlimited extra repayments, a 100% offset account and the ability to choose your repayment cycle.
Here’s a full rundown of each of these features:
Fee free extra repayments: Making lump sum payments into your home loan can really make a huge difference to the amount of interest you pay over the life of the loan. Want proof? Lets go back to Nathan and Samantha’s scenario. They were facing $25,492 extra in interest over a 25 year period thanks to the $33,820 lenders mortgage insurance they added to their home loan, which is a total of $59,312. But our extra repayments calculator shows if they made an extra repayment of $300 a month, over the life of the loan they would pay $76,484 less in interest and cut their loan by 2 years and 10 months - which would more than make up for the cost of lenders mortgage insurance!
Offset account: Another great way of reducing the amount of interest you pay on your home loan, is stashing any cash you have in an offset account, instead of a bank/savings account. An offset account is just like a regular everyday transaction account, as you can set up your salary to be deposited into it and the lender will send you a debit card to make everyday purchases. The balance that is in your offset account will then be offset against your home loan. So if you had a home loan of $400,000 and $20,000 in an offset account you would only pay interest on $380,000.
Flexible repayment schedule: Another savvy way to ensure you are paying down your home loan in the quickest amount of time possible is by setting up your repayments fortnightly rather than monthly. It’s so simple but will ultimately mean you pay off an extra month each year. For instance, repaying $2,000 a month will mean you’ll pay off $24,000 over a year. Whereas, paying $1,000 over 26 fortnights in a year will result in $26,000 being paid off, which will get you that much closer to saying goodbye to your home loan for good.
While there are home loans available allowing you to borrow up to 95% of the property value, that doesn’t mean you’ll be approved for the home loan. Here are a few tips to help you get your loan across the approval line:
1. Ditch the debt
Lenders will look at your credit card and personal loan statements to determine whether they will lend to you. So before you apply for a low deposit loan make sure you’ve paid off any balances and can show the provider that you are diligent when it comes to repaying debt. This way you will seem less risky to lend to.
2. Check your credit report
If there’s a big red mark against your name on your credit report, then this will reduce your chances of being approved for a home loan. Avoid this pitfall by downloading a copy of your report, to ensure all the information on there is in fact correct.
3. Get saving
While you may have an initial deposit for a low deposit home loan, you’ll also need to show that you have genuine savings through your bank and savings account statements (e.g not a gift from a family member). A good way to always ensure you are saving is by setting up a direct debit from your bank account to your high interest savings account each pay day.
Want to know more about the different costs involved in purchasing a home loan? Read our how much can I borrow article.Home loan features guides