Yep, we get it. A home loan can be boring. You can’t see or touch it and it doesn’t come in a range of pretty colours. However, since choosing the wrong type of home loan can cost you a lot of money over the long term, you need to choose one carefully. Not only when you’re looking for the right one initially, but also when you’re a few years into your loan and its time to check whether your home loan is still the right one for you.
We know there’s already lots of information about the different home loans out there. But since we’re always getting questions about it, we’ve put together a bit of a profile on the most common types of loans offered. It’s designed to provide a bit of a snapshot into the different options available and provide some guidance as to why one might be better than another for your own situation.
Variable rate loan
A Variable Rate loan is one where the interest rate will move up and down at the lender’s discretion (possibly influenced by RBA rate movements). This means you have to be comfortable with the idea that your repayments are likely to increase (or decrease) at some point over the life of your loan. A Variable Rate loan could be categorised as a Basic Loan or fall under a Professional Package (see below).
With a Variable Rate loan, you have the option to make Interest Only repayments or Principle & Interest repayments. You can find more about different repayment types here.
Variable Rate Loans don’t normally have a limit how much extra you can pay into them, so they’re a good option if you’re planning to pay down your loan quickly. They can also work well with a linked offset account (under a professional package loan), because the full balance of your offset account can reduce the interest charged on the loan. An offset facility also allows you to create a lot of flexibility for future you.
With a Variable Rate loan you are not locked into the loan per se so if you decide to sell your property or refinance to another lender, you won’t have to pay penalties to discharge the loan. There will be some fees, but they will not be as significant as if you were discharging a Fixed Rate loan.
Fixed Rate loan
A Fixed Rate loan is where the interest rate stays the same (or is locked in) for a defined period of time. For example, if you choose a 3yr Fixed Rate loan, the interest rate on your loan – and therefore your repayments – will stay exactly the same for 3 years. When the fixed rate period is over, the loan will normally revert to a Variable Rate loan – unless you decide to lock in for another period of time.
Fixed rate loans can be good if you like knowing exactly what your repayments will be. They are good for home owners who like certainty or investors who like to know exactly what their holding costs will be in advance. Fixed Rate loans can also be good if you lock into a rate when you expect interest rates to rise. However, bear in mind the opposite can happen too! (You can read more about the tools available to help you decide if it’s the right time to fix your loan here.)
There are generally limits on how much you can pay additionally into the loan each year without penalty, so you need to take this into account if you want to pay down your loan quickly. There can be significant break costs involved if you want to refinance the loan or sell your home.
Line of Credit
A line of credit works differently to other types of loans because there are no contractual repayments. When the monthly interest payment is due the interest payments capitalise (i.e. they are added to the loan balance).
For example, let’s say you had a $100,000 line of credit with a current balance of $60,000 and $40,000 as “available funds.” The interest rate is 4%p.a Interest Only (Lines of credit do not offer Principle and Interest repayments as an option). Instead of having a monthly repayment amount of $240 deducted from a separate bank account, the interest payable is capitalised. In our example, once the interest cost for this month has capitalised the loan balance would be $60,240 and “available funds” would be $39,760.
Over time the available funds will reduce to zero and the loan balance will reach the limit. In order to avoid ‘maxing out’ your line of credit you will need to manually transfer the monthly interest costs from another bank account after the interest has been charged.
Whilst the ongoing maintenance of a line of credit is more hands on than your typical ‘set and forget’ direct debit arrangements the functionality of these facilities (BPAY, Direct Credit and Debit, ATM access, EFTPOS) can prove handy in the ongoing management of your portfolio.
Basic loan
A basic loan can either be a Variable Rate Loan or a Fixed Rate Loan without any fancy features. There are generally no discounts offered on interest rates, no additional products offered – like an offset account or credit card – and you may pay a monthly account keeping fee. Basic rate loans can be good if you have a smallish loan size and you don’t expect to have lots of additional cash around to put into a linked offset account. They’re also good if you’re not keen on having all your banking with the same lender and just want a simple home loan without all the bells and whistles.
Honeymoon rate loan
A honeymoon rate loan is a basic loan with a special discount applied for a period of time (commonly 2 or 3 years). Over this period of time, a discount is applied to the standard variable rate. Honeymoon rate loans are good for relatively small loan amounts and you’re looking for a cheap basic loan with no additional features.
Package loan
A package loan can be any type of loan (variable, fixed, line of credit) that is taken out under a ‘professional package’. If you have more than $250,000 in lending, structuring your loan as part of a package can be beneficial since lenders offer interest rate discounts. You will generally also have access to an offset account (potentially saving you interest); annual fee-free credit card; access to a limited number of fee-free property valuations; and discounts off insurance.
Since an annual fee generally applies to the package, you need to be able to save (or park) a certain amount of cash into an offset account. Otherwise, the annual fee will be higher than the interest you save – which defeats the benefit of choosing a professional package structure.
Of course there is no rule that you need to stick to one loan type. In fact, lots of clients like to get the best of both worlds and split their home loan into a fixed rate loan and a variable rate loan. Each loan type will help to achieve a specific objective. The challenge lies is getting the balance right between a) selecting loans that help you achieve your objectives and b) not paying more than you need to for the privilege.
