Having a well-structured mortgage loan that suits the investor’s specific goals, capabilities and limitations is among the most important drivers of success in property investment. Which type of home loan will suit you best?
The lending environment continues to tighten as regulatory bodies intervene in the hope of alleviating affordability issues in the major property markets of Australia, particularly Sydney and Melbourne, which have just seen the end of an unprecedented property boom. These policy-driven changes put emphasis on the promotion of responsible lending and borrowing.
Now, more than ever, experts strongly encourage investors to do thorough research and due diligence as they seek financing for their property portfolio.
Mortgage expert Marissa Schulze said: “It is possible that we're going to continue to see some further changes and some further tightening over the next 6 to 12 months before we reach a new level of normality. At this stage, borrowers really need to be aware of what is going on and the real variance between policies amongst the different lenders.”
Find out the different types of home loan and how they can fit into your wealth-creation journey:
Among the traditional home loans available for home buyers and investors across states and territories are:
1. Principal-and-interest loans (P&I)
Through principal-and-interest loans, investors decrease the principal amount borrowed while also paying the interest on the loan. Most people choose this type of loan as it is considered a straightforward way to repay the loan in full over time, which usually goes from 25 years to 30 years.
Investors have the option to add features such as a redraw facility or an offset account for additional fees.
2. Interest-only loans (IO)
On the other hand, interest-only loans will only allow for repayments that cover the loan’s interest for a fixed period. The principal amount borrowed can only be paid down through extra repayments or after the fixed period has ended and the loan has reverted to the standard P&I loan.
At the start of the loan, investors can make lower repayments and enjoy maximum tax deductions. However, over time, this could mean more expenses since you’re continuously paying interest on a principal that is not decreasing. Therefore, once the loan becomes P&I, mortgage repayments will increase and the investor will have less time to pay it off.
Interest rates may also be higher than those of the standard P&I loans. Moreover, interest-only loans can limit the investor’s ability to build equity unless the property increases in value significantly over the interest-only period.
In order to mitigate risks, experts advise investors to implement a gradual increase in loan repayment as they near the end of the fixed period. By doing so, they can be financially prepared when the loan switches to P&I. Regular budget reassessments and interest rate negotiations are also recommended to decrease financial burden.
3. Variable rate home loans
Like P&I loans, variable rate loans are considered the standard option for property buying as they offer flexibility with minimal risk.
Mortgage repayments will depend on the fluctuations of the official cash rate—hikes mean higher repayments and drops mean lower repayments. Lenders can also make independent changes depending on their own regulations, which can make budgeting more challenging.
On the other hand, this option allows investors to pick from several attractive loan features, including the ability to make extra repayments as well as access to redraw facilities and offset accounts. True to its promise of flexibility, variable rate home loans also offer easier and cheaper ways to switch loans should the investor find a better deal
4. Fixed rate home loans
In contrast with variable rate loans, fixed rate loans are safe from the risks of fluctuating interest rates for a specific amount of time as it allows the investor to set a specific rate for a fixed period, which is usually from two to five years. When the fixed period ends, the home loan will revert to a standard variable loan unless they opt to extend the fixed period.
Having a fixed interest rate protects the loan from interest rate hikes. Since investors know the exact amount of repayment that they have to make during the fixed period, financial planning and budgeting could be a breeze.
However, investors will be missing out on certain benefits when the interest rate drops. as well as helpful loan features such as an offset account and a redraw facility. Charges may also apply should you decide to make extra repayments or pay out your loan before the end of the fixed interest period.
5. Split home loans
Simply speaking, split home loans are part-variable and part-fixed loans. The allocation of interest rate model could be 50/50, 20/80, 60/40 or whichever the investor deems fit.
Due to its structure, this type of home loan provides both security and flexibility. Investors can manage the risk of rising rates while enjoying the benefits of loan features such as the ability to make extra repayments or access redraw facilities and offset accounts.
This type of home loan is most beneficial during economic uncertainty since it reduces the impact of interest rate fluctuations as they only affect a part of your home loan. Investors also maintain the ability to take advantage of interest rate reductions through the variable-rate part of the home loan.
However, as you get the benefits of two loans, you also get both of their risks. With a split home loan, you are only partially protected from rate hikes and you can’t benefit fully from rate reductions. Therefore, if rates drop significantly, you can still incur a significant increase in repayments on the fixed part of your loan. Two-loans-in-one may also mean double fees—from setting up and managing the loan to discharging it.
6. Capped home loans
Dubbed as the ‘less risky version of a variable rate’, capped home loans essentially puts a ceiling on the interest rate. The interest rate cannot rise above the agreed capped rate, thereby protecting borrowers from significant rate hikes and effectively limiting risk.
Since the interest rate is not fixed, investors still retain the ability to take advantage of rate drops. Once the ‘cap period’ ends, they can recap their loan or choose between a fixed rate home loan and the standard variable rate home loan.
Like a variable rate home loan, capped home loans also offer beneficial loan features, including the ability to make additional repayments. It is also a generally cheaper option than fixed rate home loans.
However, you will still have to pay a rate lock fee or equivalent, which usually goes for 0.15 per cent of the loan amount. Interest rates may also be higher than the standard variable rate in the market.
Gone are the days when you have to travel far or be passed around financial managers to obtain a home loan. Virtually every bank across Australia now offers a variety of options for home lending. Even independent lending institutions, building societies and credit unions have also seen a significant rise in activity across the states and territories.
To avoid being overwhelmed by all the options available, assess the benefits and features that you want from your home loan and set a standard for your lender—both personal and financial. Can they work around your budget? Will they commit to maintaining an honest and open relationship with you?
Experts advise against making rash decisions when picking your lender as they can essentially make or break your investment journey. Instead, take your time and ‘shop around’. Let the lenders’ home loan specialists give you a clear explanation of their loan products, the processes they follow from application to settlement, their interest rates and how all their offering can meet your needs and ultimately help you achieve your goals.
You can also engage mortgage brokers and other professionals, where appropriate, or make use of online resources such as Smart Property Investment’s Loan Comparison calculator to help you compare loan products and features.
At the end of the day, property investment is a long-term commitment. Strategies could get you far ahead in the race but smart financial planning will ultimately lay the strong foundations for your wealth-creation journey.