Buying a home is super exciting. Some of this excitement, however, may be extinguished when it comes understanding what a home loan is and deciding what sort of home loan you need.
A home loan, or mortgage is a loan provided to you by a financial institution (e.g. a bank) in return for ‘security’ or ‘collateral’ over the property you are using the loan to buy. Security means that if you can no longer pay back your loan (that is you default on your loan), the financial institution can sell the property to get their money back.
Home loans come in different forms and typically are agreed to over a 25-30 year time period with regular repayments fortnightly or monthly to pay off the loan.
There are many different ‘types’ of home loans.
Combinations of owner occupied vs. investment; fixed vs variable interest rate loans and interest only vs. principal and interest. Although there are others, we will focus on these below –
This is the purpose of the property you need to home loan for. If you plan to have the property as your primary residence / live in your home, it is owner occupied home loan. If you are not and you are using it to for example earn an income or reduce your tax bill, it is an investment home loan.
Home loans are made up of two components:
Principal – the amount you need to borrow. For example, if you bought a $1.4m home (including upfront fees) and you have saved $400k, you only need to borrow $1.0m. This $1.0m amount is the “Principal”, the amount you are borrowing from the bank or lender to buy your home.
Interest – the amount you pay to the bank or lender to borrow money from them. It is often expressed as a % (interest rate) which is applied & charged to the outstanding loan amount. It is the cost of borrowing money. This changes from time to time and is set by the bank / lender. Interest rates are often spoken about on the news and are one of the costs banks/lenders charge you to borrow money from them.
So with this in mind, Principal & Interest (or P&I) home loans are ones where the amount you pay covers both interest costs and some of the principal.
Interest only (or IO) home loan, you pay off the interest part of the loan – not the principal for certain period of time (e.g. 1-5 years at a time for owner occupied home loans). This type of loan may provide lower repayments during the interest only period, but costs will then increase afterwards. Moreover, during the interest only period, you never reduce your principal (i.e. amount you have borrowed).
Fixed interest rate means the interest rate does not change over the specified duration. E.g. 4.0% fixed over two years means that your repayments will remain at 4.0% for two years. The benefit of this type of loan is that you will know exactly what you will need to pay each month for that duration of the loan.
Variable interest rates on the other hand will go up and down with bank/lender changes in
You can choose to fix some of your loan and vary the rest. For example, if you require a $1m loan, you could choose to borrow $400k with a fixed interest rate and $600k with a variable interest rate. This does get a bit more complex, but may be suitable for you.
With the Owner Occupied vs. Investment decision black and white (i.e. will you be living there or not?), the choice of which home loan you go with (P&I vs. IO and Fixed vs. Variable vs. combination) depends on your financial position & your risk appetite.
There you have it, what a home loan is and the main different types that exist. Well done on getting the home loan lingo under control!