The complete guide to how home loans work

Rates and Fees verified correct on December 11th, 2016

The complete guide to how home loans work v2

What is a home loan?

At its most basic, a home loan is simply a loan offered to a borrower for the purpose of buying a residential property, usually to be used as the borrower’s home or as an investment property. All leading banks and a number of credit unions across Australia offer home loans, although they have eligibility criteria in place for customers to ensure those who they lend money to are able to pay them back. For this reason lenders will take a look at your credit file, debts and assets carefully before approving any home loan.

But why would someone lend you money to buy a home? When a lender offers a home loan, they charge an interest rate. This rate may seem small, but over the usual lifetime of a mortgage (between 25 and 30 years) this interest nets them a profit. Your lender will use your home as security and you only completely own the home after you repay the loan in full. If you default on the loan, the lender holds the right to take possession of your home, sell it and use the proceeds to pay off your debt.

What types of home loans are available?

There are a variety of different types of home loans for a variety of different types of needs, but at their most basic, most home loans can be categorised by the way they charge interest.

The interest rate of a loan indicates the amount of interest you have to pay as part of your loan repayments. Rates can vary from one lender to the next, as well as between products from the same lender. Lenders calculate interest on home loans each month or on a daily basis. As you keep making payments towards the principal (the amount you owe), the interest you pay every month continues to reduce. Monthly repayments remain the same because of a process called amortisation, where you start paying more towards the principal and less towards the interest.

Interest rates come in two types—fixed and variable—and each comes with its share of pros and cons.

Variable rate home loan

Variable iconA variable rate home loan is one in which the interest rate can change over the life of the loan. This can happen at any time, but is most likely to happen following the Reserve Bank of Australia’s (RBA) monthly cash rate meeting.

Rates change for a variety of reasons, including the RBA official cash rates, bank funding costs, profitability and the bank’s appetite for home loans.

Some common variable rate features:

Extra repayments

Many variable rate home loans allow you to make additional repayments in order to pay down your home loan faster. This can add up to a massive savings in interest payments over the life of your loan. Have a look at the calculator below to see how extra repayments can impact the total amount you pay for a home loan.

Offset accounts

Offset accounts are transaction accounts attached to your home loan. Any funds in the account are used to offset the interest you're charged. For example, if you place $10,000 in your offset account, and you have a loan amount of $350,000, your interest will be calculated on a loan amount of $340,000 rather than $350,000. Offset accounts usually give you complete access to your funds like any other transaction account. As with the extra repayments mentioned above, offset accounts can help you save a significant amount over the life of your loan. Check out our calculator to see how an offset account can save you money.

Redraw facilities

A redraw facility allows you to borrow any extra money you’ve already repaid on your home loan. This can be a useful tool to access in emergencies, or if you’re looking to carry out renovations.

Variable rate pros and cons:

Pros

  • Features. Many variable rate home loans come with several useful features, such as the ability to make additional repayments, an offset account or a redraw facility.
  • Ability to easily refinance. When you opt for a variable rate loan, you have the flexibility to refinance with another lender if you feel you can get a better deal. Likewise, you may be able to negotiate a better deal with your current lender if other lenders have more competitive rates. With a fixed rate product, however, you would need to pay high discharge fees to exit the loan early.
  • Rate cuts. A variable rate home loan provides you with the ability to benefit if your lender chooses to cut interest rates. Even a small rate reduction could make a big difference to your periodic repayments.

Cons

  • Interest rate rise. An interest rate rise on a variable rate home loan would make your repayments more expensive, and could make your home loan more difficult to afford.
  • Uncertainty. Without the certainty of a steady interest rate, it can be difficult to properly budget for your repayments.

Compare the different types of variable rate home loan products available

Fixed rate home loan

Fixed rate iconA fixed rate home loan is one where the interest rate is set for a predetermined period of time. This is usually one, three or five years, but can be as long as 10 or 15 years. During this time, the interest rate will not change, regardless of moves by the Reserve Bank, the lender’s funding costs or any of the other pressures that prompt lenders to change rates. This also means that your repayments during this period will not change

At the end of the home loan’s fixed rate period, the rate will generally revert to the lender’s standard variable interest rate. Alternatively, your lender may offer you the opportunity to fix your home loan for a new term.

Fixed rate pros and cons:

Pros

  • Certainty of repayments. With a fixed rate loan, you’ll be insulated from any rate rises for the term of the loan’s fixed period. This means you’ll have certainty around your repayments every month and will be able to accurately budget.
  • Flexible terms. Lenders offer a variety of fixed rate terms, from one year all the way to 10 or 15 years.

Cons

  • Miss out on rate cuts. If lenders do choose to cut interest rates, you could find yourself still locked into a higher, less competitive rate.
  • Break costs. Should you choose to refinance before the end of the loan’s term, you could face hefty fees. For a rundown of the break costs associated with fixed rate home loans, head here.
  • Fewer features. Many fixed rate loans do not offer features such as offset accounts or redraw facilities or extra repayments, meaning you miss out on the flexibility offered by these features.

Compare the different types of fixed rate home loans available

Split home loan

Split rate iconIf you’re finding it difficult to decide between the certainty of a fixed rate and the features offered by a variable rate, you might benefit from a split rate home loan. As the name suggests, this type of home loan allows you to split your loan into a variable rate portion and fixed rate portion. A split facility is not a type of loan unto itself, but a feature offered by lenders on some home loan products. If you’re looking to take advantage of this feature, it’s important to ask your lender if they offer a split facility.

Calculating the real cost of a home loan

Calculating the real cost of a home loanWhen choosing a home loan product, make sure to look beyond the advertised interest rate. While an advertised fixed or variable rate might look enticing, the base rate often fails to reflect the true cost of the loan. This is why lenders are legally required to disclose what’s known as the comparison rate. The comparison rate takes into account the base interest rate along with any ongoing fees and establishment costs, and expresses this as a percentage. It’s a much better way to gauge the true value of a home loan product.

Home loans for unique circumstances

Low doc home loan

A low doc home loan can help self-employed borrowers who don’t have some of the documentation typically required by lenders. To find out if a low doc home loan might be the best option for you, read our guide.

Construction home loan

If you’re looking to build your home, you’ll need a special type of loan known as a construction home loan. These loans can also help if you’re looking to make major renovations to your existing home. Head here for an in-depth discussion of construction loans.

Line of credit

A line of credit, or home equity loan, allows you to borrow against the equity of your home. Equity is the difference between what your house is worth and how much money you owe on it. For instance, if your house is worth $500,000 and your mortgage is $250,000, you would have $250,000 in equity.

Reverse mortgage

A reverse mortgage allows borrowers aged 60 or above to convert the equity in their home into cash they can use to fund retirement, aged care or purchases. This home loan does not require ongoing repayments, but is instead repaid when the borrower sells their home. For a look at how reverse mortgages work, click here.

What do I need to do to qualify?

There are a number of questions you need to ask yourself before you begin the home loan process:

How big a monthly repayment can I afford?

It’s important to make sure a home loan will fit into your budget. Look carefully at your current expenses and make sure a regular home loan payment won’t place you under too big a financial strain.

Any lender with which you choose to apply will make their own decision about whether you can afford a home loan, and for what amount. They do this by determining your serviceability. Serviceability is your ability to repay your loan. In calculating this, lenders will add in a hypothetical buffer to ensure you’ll still be able to pay your loan should interest rates rise.

While lenders don’t make public how they carry out their serviceability calculations, you can use the calculator below to get an idea of how much you might be able to borrow.

Can I afford the ongoing costs of home ownership?

The cost of buying a house doesn’t end at paying your home loan. There are a number of other ongoing costs to consider when determining if home ownership is financially feasible for you. From ongoing maintenance and repairs to council rates and utilities, it’s important you factor the hidden costs of home ownership into your budget.

What is my credit history like?

In addition to your income, expenses and savings, lenders will take into account your credit history when assessing your ability to repay a loan. For a lender taking a risk by extending you credit, your history of repaying your debts is an important indicator of your likely future behaviour. Before you apply for a home loan, look into getting a copy of your credit report to make sure your credit history is clean. Australians can access their credit report for free. Find out how to access your credit report in our guide.

If you do have a few blemishes on your credit history, you don’t have to give up all hope of home ownership. Several lenders offer home loans to borrowers with impaired credit. Be warned, though, that bad credit home loans often carry much higher interest rates.

How big a deposit can I save?

Another factor determining the home loans you may qualify for is the size of your deposit compared to the value of the property you’re buying. This is known as the Loan-to-Value Ratio (LVR).

Determining your LVR

The size of your deposit compared to the value of the property you wish to buy will determine your Loan-to-Value Ratio (LVR). For instance, if you’ve saved $50,000 and you’re looking to buy a property priced at $500,000, your LVR would be 90%.

Lenders are often more willing to extend credit to borrowers with a larger deposit. Generally, a deposit of at least 20% is recommended. There are some lenders willing to lend up to 95% or more of the value of a property, but this comes with its own risks and drawbacks.

Which lender should I choose?

which lender should I choose

There are literally hundreds of lenders in the Australian home loan market, and each tries to differentiate itself with its products, service or the customer base it appeals to. Your choice of lender comes down to your own unique circumstances.

One thing you should keep in mind when choosing a lender is to ask them for the key facts sheet for any home loan you might be considering. This is a document lenders are legally required to provide, and it includes:

  • Loan amount and term
  • Type of interest rate
  • Comparison rate
  • Repayment method and frequency
  • Any establishment and/or ongoing fees
  • Total amount to be paid back
  • What happens if interest rates increase
  • How you can repay your home loan faster

How do I apply?

Once you’ve calculated your ability to afford a home loan, chosen the type of product that’s right for you and chosen which lender best suits your needs, it’s time to apply. There are a number of ways to go about applying for a home loan, and each has its own pros and cons. You may choose to use the services of a mortgage broker. Alternatively you could go to a bank branch and apply directly. Or you might wish to apply online. Check out our guide on the different ways to apply for a home loan.

Regardless of how you choose to apply, there are a few things you’ll need to get in order to make the application process as smooth as possible.

Home loan application document checklist:

  • Completed and signed application form
  • 100 points of identification
  • Evidence of income (pay slips or tax returns)
  • Evidence of savings (bank statements)
  • Evidence of current debts (credit card statements, contracts for car loans and/or personal loans)

Take a look at how you can help your chances of a speedy approval.

What happens after I apply?

There are a number of steps between the time you apply for a home loan to the time it reaches settlement (meaning the bank releases the funds for your property purchase). The entire process generally takes between four to eight weeks.

1. Conditional approval

After you apply, the lender will generally provide a conditional approval. This means they have assessed the amount they are willing to lend you and approve your loan in principle subject to a valuation on the property and a thorough credit check. This usually doesn’t take more than five days after the initial application, and can come through as quickly as 24-48 hours.

2. Unconditional approval

Once a thorough credit check has been conducted and a valuation report comes back, the lender will proceed to unconditional approval. Depending on the size of your deposit, this may also entail getting approval from a lenders mortgage insurance provider. You can typically expect to reach unconditional approval about five to seven days after conditional approval.

3. Loan documents signed and returned

Once you’ve been given unconditional approval, your lender will send out all your loan documents for you to sign and return. This process will take about 7-10 days.

4. Settlement

Anywhere from one to two weeks after the loan documents have been signed and returned, your loan will settle, meaning the funds are released to the vendor of the property you’re purchasing, and the title of the property is transferred to you.

What if...

something goes wrong?

If something goes wrong with the home loan process, there are a number of avenues you can pursue to ensure you minimise the damage.

I change my mind?

If you change your mind about going ahead with the property purchase, there is a period of time in which you can still cancel the sale. This is known as the cooling off period, and it varies from state to state. While you’ll be able to cancel the sale in this period, you will still end up paying a penalty in most states. Get a full rundown of the different cooling off periods across states and territories.

I have trouble paying?

If you run into trouble repaying your home loan, it’s important that you immediately inform your lender. If you’re honest and up-front about any troubles you’re having, most lenders will work with you to get you back on track. Some may offer a repayment holiday, while others might be willing to change the terms of your loan. Should your lender be unwilling to help, you can appeal to an independent dispute resolution scheme such as the Financial Ombudsman Service or the Credit and Investments Ombudsman.

I have a dispute with the lender or broker?

If you have any complaints with your home loan provider or broker, it’s best to start by taking the complaint to them directly. If this fails to resolve your complaint, as mentioned above you can seek the help of an independent dispute resolution scheme.

Marc Terrano

A passionate publisher who loves to tell a story. Learning and teaching personal finance is his main lot at finder.com.au. Talk to him to find out more about home loans.

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