Mortgage School

The different types of loans; find the one that suits your needs and goals best.

Banks and Lenders offer a variety of loans and loan structures for you to choose from when attaining a loan; each one of these has their own pro’s and con’s depending on your personal situation. To assist you with being able to identify and select the most appropriate loan for your needs, goals and financial situation, it is important to understand what each loan type and structure offers.

Keep in mind that when you get to the point of selecting your preferred loan structure, you don’t have to select just one type; there can be benefits for you to select two or more options.

The terms Mortgage and Loan are used interchangeably, but they are two different things.

A loan is where the Bank or Lender provides you an amount of money, in exchange for periodic payments.
A mortgage where you give the loan provided (usually a Bank) your house / asset as ‘security’ in case you are unable to make payment. It is held a bit like a collateral.

The components of a loan:

Principal and Interest:

Principal is the amount you are actually borrowing from the bank; the amount you will receive from the bank at settlement.
Interest is the amount charged by the Bank or Lender for you to borrow the loan amount.

Loan term:

The loan term is the period in which the Bank or Lender requires you to pay the loan off in. You can also select a shorter loan term if your financial situation allows you to pay off the loan in the shortened period. Factors that influence the loan term depend on your circumstances like your current age. In most cases, the Bank or Lender will offer a loan term of between 15 and 30 years, but may be as short as 1 year.

The longer the loan term offered, the longer you have to pay off the loan.

Benefits: as you have longer to pay, your weekly / fortnightly / monthly payments are lower.

Consequences: as you are borrowing the money for a longer period from the bank, you will be paying off more interest during this time as you act to pay down the principal amount. The more interest you have to pay over the period, the more expensive your overall loan will be.

Depending on other factors in your loan structure, you may be able to make your regular payments on your loan larger than the Bank or Lender requires, or you may be able to make periodic lump sum payments against the loan – this will allow you to pay the loan off in a shorter period. We will get into this in more detail later.

Interest Rate:

the interest rate is the amount that the Bank or Lender charges you for borrowing the money (the loan). Interest rates are either variable or fixed.

Variable rates:

These rates are sometimes referred to as the floating rate.
The variable rate is a rate that is usually higher than the fixed interest rate offered by the Bank or Lender. This rate is influenced by changes in the Official Cash Rate (OCR) and as the name suggests, it can change, or vary at any time.
A risk with the variable rate is that there is limited stability in your periodic repayments; if the variable rate goes up, your repayment amount will increase, but if the rate goes down, then your periodic repayment will decrease.
With risk can come reward; as mentioned under Loan Term, it is possible for you to pay your loan off over a shorter amount of time – this is where a Variable Interest Rate loan is beneficial.
Under the Variable interest rate loan type, the Bank or Lender will provide you a minimum amount you are required to pay; this allows you to pay any value above that.
You may wish to make increased payments on your regular payment (e.g. pay 10% more than required) or periodically pay off lump sum amounts (e.g. an additional $1,000 every quarter).
For example, if the Bank set your minimum monthly payment at $500, any amount you paid above that will be taken off the principal amount only (the actual amount of money you received from the Bank), this reduces the amount you are borrowing at that point, and as interest is paid on the principal amount, this reduced principal reduces interest payable, ultimately assisting you in paying off the loan over the shorter period of time.

Fixed rate

As the name suggests, the Fixed Rate is an interest rate offered by the Bank or Lender that is set at a particular value, for a period of time.
Unlike the variable rate which will move in response to changes in the Official Cash Rate and other influential factors, the fixed rate remains as it is for the period for which it is selected.
While fixed rates are fixed, the rate offered is different depending on the period of time you would like to fix it for. Each fixed rate period offers a different interest rate that is secured for that period.
These fixed rates can be fixed for a variety of time periods, depending on the Bank or Lender. In most cases they range from fixed for 6 months to fixed for 5 years.
For most people, the benefit of the fixed rate is that they have certainty and stability for their regular loan repayment amounts. Under a fixed rate, the periodic payment will be the same on the first payment, as every other payment throughout the loan. For example, if you choose a 5 year fixed rate, paying monthly, your payment every month for 5 years will be the exact same amount
A consequence of having this payment certainty and stability is that fixed interest rate loan terms generally don’t allow for you to make additional payments, or larger payments than the minimum amount. This means that you will be more likely to be paying the loan off up until the final period of the loan term, and no sooner.
Another disadvantage that may be experienced with a fixed interest rate is that if you fix your rate at a time when the interest rates are high, when the interest rates go down such as from changes in the OCR, you will be unable to change to the lower rate, and if you do, you may be required to pay the Bank penalties.
At the end of the fixed rate period, you can choose to select another fixed rate period, or move the loan across to a variable rate. Your choice may be influenced by the activity in the interest rates, for example whether they are going up, or going down.

Table mortgage

This is the most common type of mortgage. It can have a fixed or variable interest rate. Your regular repayments are initially calculated to be the same each time and to ensure your mortgage is fully repaid by the end of the chosen term. Whenever your interest rate changes, the calculations are done again to achieve the same goals. So your regular repayments will go up or down accordingly.

To begin with, your regular fortnightly or monthly repayments are mostly paying the interest owed each time and repay very little of the amount you borrowed (principal). Gradually as you repay some of the principal, the amount of interest charged decreases, so your regular repayments repay slightly more principal. Towards the end of your mortgage term, your regular repayments are almost entirely repaying principal and the amount owing rapidly decreases.

Although this type of mortgage can take longer to repay than some others, the main advantage is the initial repayments are more affordable and reasonably consistent, apart from changes in interest rates.

Reducing mortgage

These mortgages are quite rare and typically only suit people who can afford high repayments initially, but expect their income to reduce in the near future. An example would be a couple nearing retirement, where one of them will be stopping work in about five years.

With a reducing mortgage you repay the same amount of principal (the money you borrowed) each time. Your interest repayments start on the full loan amount and gradually reduce as you repay more and more principal. As a result, your regular fortnightly or monthly mortgage repayments steadily decrease.

This means you pay much less interest overall, compared to a table mortgage over the same term. However, most people who can afford higher initial repayments would save even more by continuing to pay that amount with a table mortgage.

Interest-only mortgage

As its name suggests, with this type of mortgage your regular fortnightly or monthly repayments only pay the interest owing each time. That means you don’t repay any of the amount you borrowed (principal) and keep paying interest on the full amount. The main advantage is that you’ll have the lowest possible regular mortgage repayments.

Interest-only mortgages are typically only suitable for some property investors, who want to keep their costs down while they renovate a home to add value or until they resell. These mortgages may also suit some first home buyers who are certain they’ll have significantly more income or fewer expenses in a couple of years’ time. When that time comes, they can change to a normal table mortgage with its much higher regular repayments.

The maximum term for an interest-only mortgage tends to be only five years. After that they usually revert to a table mortgage, although you could apply for another interest-only mortgage and see what the lender says. Because you’re not repaying any of the principal, lenders are often reluctant to approve interest-only mortgages, in case property values drop and the home ends up being worth less than the amount you owe.

Offset mortgage

With these mortgages you can link savings and everyday transaction accounts with the same lender to your mortgage. The total amount in the linked accounts is subtracted from your mortgage balance before the interest is calculated. The interest is calculated daily and paid monthly, so the more you have in the linked accounts and the longer you leave it there, the less interest you’ll pay.

Some lenders let your close family members link accounts to your mortgage as well. These family members keep sole access to the money in their account, but it helps reduce the interest you pay on your mortgage each month. They can also unlink their account whenever they want to.

The main disadvantage of offset mortgages is they can only have a variable interest rate. These are usually higher than fixed interest rates and don’t offer the same certainty. The other disadvantage is the money in the linked accounts doesn’t earn interest; however the interest avoided (saved) by offsetting will always be greater than the interest lost by not having the money in a savings account.

People often split their borrowing between an offset mortgage and a fixed mortgage. They make sure the size of the offset mortgage is close to what they expect to have in the linked bank accounts, so the higher and variable interest rate has a minimal downside. There’s more about splitting mortgages below.

As you repay your offset mortgage, you may end up with more in your linked accounts than the remaining mortgage balance. If so, one or more of the accounts can always be unlinked, perhaps a close family member’s account, so they start earning interest again.

Revolving credit mortgage

These mortgages offer maximum flexibility, but only suit people who are very disciplined when it comes to managing their money. Here’s why:

A revolving credit mortgage is like a large overdraft facility. You agree to a maximum borrowing limit, then you’re free to draw down (withdraw) or repay money as often as you choose. The interest is calculated on the daily balance and paid monthly from the same mortgage account.

A revolving credit mortgage operates just like a normal transaction account; you can access it using EFTPOS, ATMs, internet banking and so on. In fact, most people use it as their everyday account. They pay their income directly into it to reduce the balance owing. They also keep the money there for as long as possible, by paying for things on a credit card and only repaying that in full at the end of each interest-free period. It’s a great way to save on interest and even small savings can really add up over the life of the mortgage.

Revolving credit mortgages can also be particularly suitable for people with an irregular income, such as freelancers, contractors and seasonal workers. You don’t have to make regular mortgage repayments and when you receive income it can be immediately used to full effect, reducing the balance owing and interest charged.

The freedom to easily draw down money can also suit people who’ve bought a home with value-adding renovations in mind. They don’t have to start paying interest on the money required until they make the purchases or pay the invoices involved.

The main downside with revolving credit mortgages is the temptation to spend up rather than repay the amount you owe. The higher your loan balance each day, the more interest you’ll be charged each month, which is simply added to the loan. Some lenders offer revolving credit mortgages with a decreasing limit. This effectively adds a term to the mortgage and can help to keep you on track to repay your mortgage as planned.

Like offsetting mortgages, another downside of revolving credit mortgages is they only come with a variable interest rate. This allows you the freedom to deposit and withdraw up to the limit at will, but variable rates are typically higher than fixed rates and they can increase, or decrease, at any time.

A big difference between offsetting and revolving credit mortgages is the latter is an all-in-one account. With offsetting mortgages, your money is in separate accounts and potentially easier to keep an eye on.

Reverse mortgage

Only available for people over 60 who own their home outright, these mortgages require no regular repayments at all. They’re designed to help older people, who no longer have the income to repay a normal mortgage, access some of the value in their home without having to sell and move on.

The interest charges are simply added to the loan, which compound and grow at an increasing rate until the borrower downsizes to another home, moves into full-time care or passes away. The proceeds from selling the house are then used to repay the eventual balance, including the accumulated interest, which can be quite substantial. The remainder is paid to the borrower or their estate.

To ensure the value of the home will always be enough to repay the final amount owing, you can only borrow a percentage of the home’s value at the time of taking out the mortgage. The younger you’re, the smaller the percentage you can borrow because the amount owing is likely to grow for longer. It’s typically 15% at age 60 and rises steadily to 45% at age 95.

With all mortgages, and particularly reverse mortgages, it’s very important to seek independent advice from your solicitor to ensure you understand what’s involved before signing anything.

See our in depth guide to reverse mortgages.

Split or combination mortgages

Most people split their borrowing between two or more types of mortgage. Done well, it can greatly reduce the interest you pay over the life of your loans. It can also help to reduce the risk of having your entire mortgage in what turns out to be a less favourable type. It pays to get experienced advice to identify the options that might suit your current and future circumstances.

Combinations might include:

One-year fixed plus three-year fixed rate table mortgages – to reduce the impact of interest rates being high when a fixed interest rate period ends
Variable plus fixed rate table mortgages – to let you make some repayment increases without an early repayment penalty and also have the certainty of a fixed rate
An offset mortgage plus one-year and three-year fixed table mortgages – to take advantage of money in linked accounts, while also enjoying typically lower fixed rates, more repayment certainty and reduced risk for most of the borrowing

Putting it all together in an example

Here’s a fictitious example of how two people chose particular types of mortgages and their reasons for doing so:

A temporary boost from ‘the bank of mum and dad’

Best mates Nat and Sarah were well into their 30s and keen to get a place of their own so they could put their DIY and interior design skills to work. They combined their savings and had enough for a deposit on a modest two-bedroom unit. Both had stable and reasonably well-paying jobs, and although they could afford the mortgage repayments, there would be almost nothing left over for renovating.

Neither set of parents had money they could gift to Nat and Sarah, but they did have ‘emergency’ money in savings accounts earning very little interest. They were happy to link these accounts to an offsetting mortgage for the next five years or until an emergency occurred.

After paying the deposit, Nat and Sarah needed to borrow $500,000 to buy the unit. They split the loan between a $50,000 offsetting mortgage, a $200,000 one-year fixed table mortgage and a $250,000 three-year fixed table mortgage, all on 30-year terms to keep the initial repayments as low as possible

Both sets of parents opened savings accounts with Nat and Sarah’s mortgage lender, each depositing $20,000 of their emergency money, so a total of $40,000. These accounts were linked to the offsetting mortgage, bringing the balance for interest down to $10,000. The variable interest rate was 5%, so the $40,000 offset would save Nat and Sarah around $2,000 a year.

Nat and Sarah had their incomes paid directly into their everyday accounts and linked these to the offsetting mortgage. They also opened a separate savings account for the future renovations and linked that as well.

Nat and Sarah knew they could afford the full mortgage repayments without their parents’ offsetting, if they had to. They worked out how much all the offsetting was saving them each month and set up an automatic payment for this amount into the renovation account.

automatic payment for this amount into the renovation account. Five years later they had completed some great value-adding renovations and their parents’ unlinked their savings accounts as planned. Nat and Sarah were now earning more than before and could make their own contributions to the renovation account. They couldn’t offset as much as their parents’ savings had, so they reduced the offsetting mortgage by $30,000 and took out an additional fixed interest mortgage for the same amount, but on a more attractive and consistent interest rate.