Bank jargon can be very confusing with fixed and variable rates, split loans, interest only and principle plus interest… but what does it all mean?
Types of repayments
Principle plus interest
Principle plus interest loans have payments calculated to repay the loan within a set term, typically 30 years – though it can be less. Each payment consists of an interest component and an amount to reduce the principle (the loan balance). In early years the principle reduction is relatively small, but this does increase over time as the interest charge reduces with the loan balance reduction. You can speed up the repayment of your loan by increasing your repayments as any extra you pay becomes a direct principle reduction.
Interest only loans are exactly that. You only pay the interest, and the loan balance does not reduce. These loans have fallen out of favour with the banks in recent years, largely due to government regulatory pressure. While they are still available, borrowers are penalised with higher interest rates and restrictive lending criteria to establish eligibility. That said, some people still opt for these loans as a means of reducing cashflow pressure, though it should only be considered for a short term for owner occupied lending. It is a better vehicle for home investment loans as they provide certain tax advantages, and that is a discussion outside the scope of this article!
If your loan is interest only, you are restricted to monthly repayments. With principle plus interest repayments you may choose to pay your loan weekly, fortnightly or monthly. Ideally you will nominate the same repayment frequency as your pay cycle as it makes budgeting easier. If you choose weekly or fortnightly repayments you may also repay your loan more quickly as you are squeezing in two extra repayments over the course of a year as there are 26 fortnights as compared to 12 months.
Types of loans
Variable rate loans
Variable interest rate loans are all about flexibility. Essentially, with a variable rate loan, the interest rate moves up or down as the market moves. This means your loan repayments may also change month-to-month.
If the interest rate drops, then your repayments may drop as well. However, in the event of an interest rate rise, your repayments could also increase.
Many variable rate loans come with additional features, such as offset accounts and redraw features. Variable rate loans also offer flexibility in terms of increased payments, allowing you to pay off your loan faster if you have additional funds available.
How an offset account works
An offset account is a transaction account that has been linked to your variable rate loan. You do not receive interest on this account, but the bank reduces the interest payable on your homeland. On a daily basis calculations are made by the bank comparing the balance of your offset account with your home loan, and interest is calculated on the difference between the two accounts.
For example, if you have $20,000 in your offset account and $400,000 owing on your mortgage, the interest on your home loan is calculated on $380,000 instead of $400,000.
While your repayments remain the same, you’re paying less interest, which means you will be paying off more of the principal. If you can maintain a significant offset account balance you can potentially pay off your mortgage years earlier than with another type of loan.
What is redraw?
A redraw facility allows you to withdraw repayments that you have made to your loan that are in addition to your scheduled repayments. This could be particularly useful if you want to save for a car or holiday, and have the advantage of reducing your home loan interest charges while you do so.
Fixed rate loans
A fixed rate loan is one where the interest rate is fixed for a limited period and immune from any movements in the market. The most popular choices are three and five-year fixed interest loans, although options ranging from one to ten years are available.
Fixed rate loans allow you to make steady, regular repayments. They’re great for borrowers on strict budgets, or if you’re entering into a mortgage at a time when interest rates are likely to rise.
In the event of a drop in interest rates, being locked into a fixed rate may mean your repayments are higher than they otherwise would be. It’s also worth noting that breaking a fixed rate loan can potentially cost thousands of dollars in fees.
Additionally, many banks will charge you a fee for making extra payments towards the loan during the period it has been fixed.
Split rate loans – a foot in each camp
A split rate loan is when you break your mortgage into two loans – one with a fixed rate and one with a variable rate.
It’s something of an ‘each-way bet’. A split loan offers borrowers protection from rate rises (with the fixed portion of the loan) alongside the advantage of rate drops (with the variable portion of the loan).
Most banks will allow you to split your loans from the outset, without having to pay for two separate loan applications.
Professional or packaged loans
Many lenders offer mortgages that provide ‘lifetime’ discounted interest rates, fee waivers and linked savings accounts and credit cards. These options are generally offered on high loan amounts. Additionally, certain professionals such as doctors, lawyers, engineers and accountants may be able to access finance up to 90% of the purchase price without Lenders Mortgage Insurance (essentially a risk fee for loans over 80% of property value).
Choosing the right kind of loan depends on your personal situation, earning capacity and long-term goals for your property.
As ever, please feel free to ask me any questions and let me know if I can assist you in this journey!