Home Loan may sound simple at first, but as soon as you do a quick Google search, you will be flooded with millions of choices. The question is no longer just about which bank has the cheapest rate, you also need to decide on fixed or variable rate, should I go with Redraw or Offset, and what is Interest-Only payment?
Today, we will go through the most fundamental choices you need to make for a home loan in Australia.
Choice #1 - Owner-Occupied or Investment loan
Starting from around 2017, Owner-Occupied loans started to have a slightly lower rate than Investment loan. On the other hand, Investment loans are tailored for rental properties and you can receive tax benefit from these loans.
You may ask yourself “if I am buying a home for the first time, of course it would be to live in, why would I even consider an investment loan?”. And for many of you, this would be correct, sometimes this choice has already been made when you decide what the property will be used for.
However, consider the following questions:
What if you love where you are renting but still want to get onto the property ladder?
You can consider buying where you rent, but what if it is way over your budget, and buying something affordable means 2-hour commute to work?
You can consider buying an investment property first to get the benefit of the real estate market. When your finances improve later, you can sell it and buy your own home where you want it to be.
Depending on your circumstances, the loan you can borrow can be very different based on this decision, and it can be quite an involved process to work out what you want to do.
Choice #2 - Principal & Interest or Interest-Only Loan
These are how you can pay your loan every month.
Principal & Interest is the most common type and also the most straightforward. Every month, the bank requires a certain amount of payment, one part interest, and the other part principal. This will ensure you pay down the original loan within its term, usually 30 years.
Interest-Only works a bit differently. For a set period of time, usually 1 to 5 years, you pay no principal at all. Your repayment is purely interest. After this, you can either go on another Interest-Only period, or start paying principal depending on your strategy.
Now, Principal & Interest rate is typically lower than Interest-Only, because it is a safer type of loan to the bank. After all, Interest-Only loans are not paid back until much later. However, also because you don’t pay principal, Interest-Only repayment can be lower, despite the higher rate.
"Interest-Only repayment can be lower, despite the higher rate."
You cannot pay Interest-Only forever though, and will have to start paying principal at some point. When this happens, the bank will require you to pay at a faster pace to catch up. Principal & Interest payment does not change at all, this will stay the same until the loan is paid off, all else being equal.
As a result, this decision can have major impacts on your cashflow and overall interest you need to pay, especially over the long term.
Choice #3 - Fixed rate or Variable rate
As you can tell from the name, a fixed rate loan means that your rate is set and will not change for a number of years. Now, I said “a number of years” because you cannot fix your rate for the life of the loan. There is no such loan as fixed-for-life in Australia, they all revert to variable rate after a certain time.
For example, if you get a loan at 6% with a 5-year fixed term, you will pay 6% interest on the loan for the next 5 years, even if the same bank drops to 4% or increase to 8% next year. After 5 years, the loan automatically becomes variable, or you can fix again at whatever their rate is at that time.
Variable rate is the exact opposite, your rate is subject to change from the very beginning. Until early 2022, rates had been going down continuously so variable rates were very popular. Things have changed a lot, and rates have been going up rapidly since then, but it does not mean going fixed is the best option right now. Exactly because rates have gone up so much, there is now a good chance that they might go down in the near future. If this does happen, fixing your loan now mean you will be stuck with a higher rate than you should have.
Other Considerations
While the above three choices are the most important, you will also be presented with the following questions regarding your loan:
How long the loan term should be? The longer it is, the lower your repayment would be, but you will also pay more interest overall.
How often would you like to pay (monthly, fortnightly, or weekly)? Paying more frequently reduce overall interest slightly. The main consideration here is which one is more convenient for you.
Should you go with Offset or Redraw? This can get complicated really fast so I will go into more details in a later post. For a quick overview, they both help reduce interest you pay each month though Offset is more convenient but have extra costs.
There are some flexibility with these and they don’t fundamentally change how the loan operates. They are also relatively easy to change to better suit your need later.
And that’s it, three common yet very important decisions to make for every home loan.
If you have any questions that you wish I had covered, do leave them in the comment section and I will be sure to answer them.
Until next time, stay sensible.
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