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Which home loan is right for you?

In this article:

IO, P&I, Fixed Rate, Variable, LVR – What are the factors that influence the cost of a loan?

Stepping into the world of home loans may seem daunting. There are so many options and so many technical words. With different interest rates for different types of loans, it’s important to understand what each one means and how they can affect the cost of borrowing.

We’ve provided a jargon-busting explanation of some of the key terms and what they mean for you. While it’s always best to get help from a professional, this will give you an idea of some of the terms you might hear.

Principal & Interest vs Interest Only – There are two components to any loan you take out: the amount you borrowed (the principal) and the interest payable on that amount.

Principal & Interest (P&I) is where you pay down the amount you borrowed as well as the interest. You’re reducing the overall cost of the loan by paying it faster. This is the most common type of loan.

Interest Only (IO)is more complicated. Because a home loan tends to be a large amount of money, the interest itself is a major part of the cost.

In an IO loan, you only repay the interest component at first – usually for a period between one and five years. After that, you revert to making both principal and interest repayments.

These loans are more suitable for investors keen to manage their tax obligations.

Consider the example of Janet. She has a home loan for the property she lives in and pays P&I on this loan.

However, Janet also owns an investment property with a corresponding loan.  The investment property provides a rental income and the interest from the investment loan is a valid tax-deductible expense.

Janet wants to pay her primary home loan down as rapidly as possible to save on interest. But, all else being equal, to free up as much cash flow to reduce that debt as rapidly as possible, she could make the absolute minimum, interest only payments on the investment loan.  This allows for maximum cash flow to be directed to minimising the non-tax-deductible debt (the home she lives in).  However, the important factor to consider here are the words: all else being equal.

Until recently, the interest rates for P&I loans and IO loans were generally the same. However, with changes in the marketplace, there is now a considerable interest rate premium payable for interest-only payments.  This could make the decision more complex when it comes to determining what strategy is appropriate for your individual circumstances. As the interest rate premium on Interest Only loans increases, the number of people this strategy makes sense is decreasing.

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Fixed vs Variable Rates

Within the P&I universe, there are two further decisions to make. You can choose between:

Fixed Rate (P&I) - These are priced according to a pre-determined interest rate and therefore have fixed repayment amounts. You can usually ‘lock in’ your repayments for between one and five years. When the fixed term expires, you decide whether to fix the loan again for another period of time at the current market rates or convert the loan to a variable interest rate.

This approach can make it harder to pay off your loan early, because you’re locked into a repayment schedule, and the loan products may offer fewer features such as offset and redraw. It’s best to speak to a mortgage adviser to be sure.

Variable (P&I) - The rate charged on variable loans moves up or down in line with interest rates. A basic variable has fewer features and flexibility than a standard variable, which may typically offer low introductory rates and the ability to make additional payments (redraw).

One upside of this type of loan is that if interest rates go down, yours does too – whereas a fixed rate leaves you locked in. However, it also means they can go up – so if you prefer to have your repayment levels set in stone for the foreseeable future, a fixed rate loan might be better for you.

Split Rate (P&I) – This is a ‘best of both worlds’ approach.  You can divide your loan between fixed and variable interest rates, and you choose how much to allocate to each.

Interest-Only -  You repay interest only on the loan principal for a period of between one and five years. At the end of this period, you revert to making both principal and interest repayments. Line of credit A line of credit allows you to access additional funds by drawing on the equity value of your home. After fixing a limit on how much you can borrow, you direct income from all sources into your loan account and then draw down funds as required.

Owner-Occupier vs Investor Loans

It’s clear what the difference is here: you’re buying a home to live in or one to invest in and rent out. That’s clear. But what does that mean for your loan?

The way that lenders look at risk – i.e. the risk of lending money to you – owner-occupier loans are safer. People work hard to keep a roof over their head and it’s where their biggest focus goes in a financial sense.

Investors have more variables – including whether they can keep a tenant in the property. They may be negatively gearing as well, meaning the investor has to find money each month to cover the shortfall between loan repayments and rental income. That’s why lenders treat these loans in a different light – there’s a higher risk of default.

In addition, moves by the banking regulator to manage the growth of investor loans has meant that many of these products have increased in price over recent months.

Loan to Value Ratios

One more factor that may affect the home loan rate you receive is your level of equity (i.e. how much you own of the property). If you’re a first home buyer, getting to a level of 20% deposit can be challenging. While this is a lender’s favoured minimum, some of them will go below that.

But they’ll manage the additional risk by increasing rates and/or requiring you to take our Lenders’ Mortgage Insurance (LMI). This is a policy you pay for, but which protects the bank if you default on your loan. If the bank has to sell the property but it goes for a lower sum than what’s owed to the bank, LMI covers the shortfall.

Buyers who have already property owners for some time tend to have more equity, as their home will (hopefully) have increased in value. This means they may have a more favourable LVR in the eyes of the lender, and be able to secure a better deal.

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