With housing prices on the rise and desperate homebuyers looking at alternatives to regular mortgages, risky home loans have become more popular.
Kim Wight, Personal Mortgage Advisor at Smartline, explains why you should steer clear of these loans.
Since the start of 2013, the median price of the average Sydney property has increased to over $600,000 making it increasingly difficult to afford a new home. Many Australians are now considering ‘risky’ home loans — but don’t sign on that dotted line until you’ve taken a second look at the features of these loans.
In addition to risky home loans, there are also risky property types that can make lenders nervous.
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Kim Wight from Smartline Personal Mortgage Advisor Shares home loan considerations
Click here for video transcript:
When people are looking for a home loan and they need to take on a guarantor — which is mainly because they do not have enough savings to cover mortgage insurance and stamp duty — the risk really isn't to the borrower. The risk is all placed on the guarantor. And I think a lot of young people think, "Oh, mum and dad will just put the house up for me," which might seem like a really good idea to you, but isn't the best thing for the parents. So there's a definite risk involved, and I think a lot of people don't think about it completely before they enter into these agreements.
With equity loans, it's very open-ended. So there's no set repayment schedule. What people can do, it might seem really attractive to have this equity loan where your limit might be $500,000, but you've got no set repayments. So you can have that loan and still in 30 years time, owe $500,000, because you've never paid down any of the interest. Equity loans are great for investors or people that are really controlled with their finances. But for the majority of people, though, they'll get an equity loan today and in six years time they'll say, "Kim, why do I still owe the same amount of money?" And it's because they've never kept making those regular repayments. Or if they do, they just keep drawing up to their equity limit. So a line of credit or an equity loan is really only for the very controlled borrower.
If the idea is to buy it, and then it might be your long-term property or you would be selling that to buy a family home, the best loan is a term loan with a beginning and an end date. And I advise them to pay as much as they can as often as they can. I believe a variable rate is the best for them, because fixing a rate really locks them in, and they don't know what their plans are longer term. So [use a] term home loan with set repayments, but pay as much as you can as often as you can.
Guarantor home loans
In today’s property market it can be difficult to come up with a deposit for a new home. Many lenders will allow a related third-party to provide additional security to help a family member own their own home, commonly known as a guarantor.
‘Often when people cannot borrow the amount of money they want to purchase the property, they throw out the line “so and so will go guarantor” — well this just does not work anymore’ says Ms Wight. ‘Before lenders will consider a guarantor on a loan they have to be convinced that there is a commercial benefit to the guarantor to enter into the agreement. If there cannot be a financial benefit to the guarantor they will only be considered as a co-borrower on the loan.’
A guarantor is linked to the loan by a guarantee and can be released without the loan having to be repaid in full. It allows the equity in his or her own property to be used as an additional security for the borrower’s home loan, which means that the lender can also take over the guarantor’s property if necessary.
‘An example of this would be a homebuyer whose income does not service the debt. They want to have a member of their family as guarantor. In this transaction there is no benefit to the family member as they would be taking the risk in having to make payments on the loan, but not have the benefit of owning the property’ explains Ms. Wight. ‘The only way the lender will consider this is if the family member was a co-borrower on the loan and have a percentage holding in the property.’
If the bank is unsure that you will be able to meet the minimum repayments for a home they may ask for a guarantee from somebody else. In some cases, it may be the parents. ‘The other guarantee used is commonly known as a Family Guarantee’ explains Ms Wight. ‘This means that the bank will lend the borrower 80% of the value of the property being purchased while the borrower’s parents offer their property as extra security to cover the remaining 20% plus costs of stamp duty and legal fees if required.’
It can be tricky using a guarantor since quite often their home is used for security. In the past, 100% of the home was liable in the case of defaulted payments, but now lending institutions can go as low as 20% of the home being liable. The loan still poses a considerable risk, however, since both homes can be sold by the bank if there is a major problem.
Any guarantor has certain rights. Statements can be received for loan payments and they should be monitored. Before making the decision to guarantee a home loan, the guarantor should find out what would happen if the borrower could no longer make repayments and if there are chances that the home could be repossessed.
The guarantor also needs to acknowledge hidden costs such as a home valuation and whether it is possible to be released from this guarantee. Some institutions will allow a release once enough equity has been built up in the home. Sometimes this release will incur a fee so it is important to find out how much that will be.
Mortgages with a Loan-to-Value Ratio (LVR) of more than 100%
Similar to home loans with no deposits, these risky home loans were offered by some financial institutions, although they are almost impossible to find after the global financial crisis. Lenders made it available so that homebuyers didn't have to worry about all of the extra charges, such as legal fees, that go along with a house purchase. However, this loan may take a longer period to repay as it doesn't even take into account price changes in the housing market. If your home loses value, it will take even longer pay down the loan balance to reach the 100% LVR and 80% LVR mark unless you can make extra payments. If the house rises in value, you will reach these values sooner. Before getting this type of home loan you'll have to look at the potential cost of Lenders’ Mortgage Insurance (LMI). These types of loans can be very costly and unless you can make extra payments from time to time, you will end up paying extra in interest. It is always best to get as much of a down payment as you can for a house payment before applying for a mortgage. If you can save more than 20% then you'll eliminate the cost of LMI altogether.
As mentioned above, LMI only insures the lender, not you, in the case something happens and you cannot pay off the loan. If the lender had to sell the home for less than the value of the mortgage, the lender would be covered. Even though the lender is protected and gets compensated for the loss, you are still responsible for the debt. The cost of mortgage insurance can be high enough that you may want to consider looking twice before taking on high risk home loans that require it. Have a look below to see the difference between having a deposit of 15% vs a deposit of 5%.
Lenders’ Mortgage Insurance
|Property value: $250,000|
|Loan-to-Value Ratio||Lender’s Mortgage Insurance|
|85%||$1500 to $2000|
|95%||$6000 to $7000|
|Property value: $400,000|
|Loan-to-Value Ratio||Lenders’ Mortgage Insurance|
|85%||$3000 to $4000|
|95%||$13,000 to $14,000|
Read the box below to find out how the a home loan with an LVR of over 100% usually works in terms of paying it off and reducing the amount you owe.
You could previously get a loan for $250,000 for a home that has a value of $236,000, meaning the loan had an LVR of 106%. If you took out a mortgage for 30 years at a rate of 8% and made all the repayments that are minimally required, you would not be down to an LVR of 100% for 5 1/2 years. To get down to an LVR of 80% of the home's value would take you 15 1/2 years.
The new 40 year mortgage may seem appealing at first because it offers lower monthly payments, but don't be fooled by it. It's not cost effective and you may end up paying thousands more in the long run.
If you take out a long-term mortgage simply to save money on a monthly basis on a 30 year mortgage, you will end up paying thousands of dollars more in interest. If the rate of interest goes up, you will be left in a serious situation and may end up losing the house anyway.
40 year mortgages
Here are two examples of getting a mortgage with different year terms.
These differences are very substantial and not always recognised unless the numbers are first crunched. While it can seem very positive to pay less money every month for a mortgage on a longer yearly term, you will end up paying the price in the end.
Mortgage specialists will tell you that you should always leave a 2% buffer for the interest rate whenever you are considering a home. Different banks and financial institutions are making 40 year mortgages available to their customers. The positive note to this type of mortgage is some institutions will allow you to pay extra on your monthly payments without having to incur any penalties. This means that if your financial situation doesn't improve, you have the option to get it paid back in as little as 30 or 15 years.
Considering interest charges, you may want to consider taking the shortest mortgage term you possibly can. As you can see from the case studies there is a big difference in the interest charges you will have to pay. Also, consider that any rise in interest rates can lead to problems in the future.
Equity Finance Mortgage
A shared equity home loan is available in every state except Tasmania and the Northern Territory. It is offered in some metropolitan areas and capital cities. It allows you to get a loan for 10%, 15% or 20% of the property value under a shared appreciation mortgage, which provides the deposit aspect of your purchase. When you sell the house in 25 years the initial amount of the EFM loan needs to be paid back plus a percentage of the increase in value in the property since it was purchased. If you take a loss on the sale of the home, a percentage amount is usually is covered by the lender. This amount will then be deducted from how much you have to pay back. You may or may not be able to combine this type of loan with a home loan from another bank. Another downfall to this type of mortgage is that the capital loss is not shared by the lender if the house is sold for a lesser amount than it was originally purchased for and if you have gone into default on the loan.
EFM home loan example
|Amount you need to pay back||$164,000|
|Amount paid back in interest charges||10.6%|
If a normal home loan had been taken at the same time as the above example, the interest rate would have only been 9.5%. Regular payments would have been made with a regular loan instead of paying a lump sum.
If instead you had been able to repay the $20,000 within a couple of years, after the jump of prices in housing during 1988 and 1989, you would have owed the bank $49,137. This calculates to an interest rate of 45.8%. It can be very difficult to estimate whether property values will be going up or not, which could make this home loan rather risky.
When borrowing money to purchase or refinance a home, you should always proceed with caution. The type of mortgage you choose can make the difference between owning your property outright, or finding yourself in a stressful financial situation. There are many different home loans available from a wide range of lenders, but if your financial situation necessitates risky loan, you may want to review all the conditions and terms of the contract with an advisor beforehand.