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Purchasing a property, and taking on a mortgage, is one of the biggest financial decisions most Australians will make in their lifetime.
Your choice of property will be a large factor in wealth accumulation over your lifetime.
The total price of a property can be doubled (or more) by interest paid over the life of the loan. Luckily we are currently in record-low interest rates, although it is unclear how long this will last.
The interest rate you pay makes a massive difference over 30 years to how much you pay for a property. Should you rely on the comparison rate to make your decision?
Even paying 0.5% extra in interest over 30 years for the above $500,000 property results in an extra $44,000-$65,000 in interest charges over the life of the loan.
But it’s not just the interest rate that’s important. Annual fees act in a similar way to interest and blow out the cost of a loan over the long term. Then there are establishment fees, exit fees, redraw fees, introductory rates and special features such as offset accounts and lenders mortgage waivers.
The result is enormous confusion for first-time buyers and refinancers! A mortgage broker can help you compare like with like, and make recommendations based on your personal circumstances. It is wise to invest some time educating yourself on options given mortgage brokers have a conflict of interest in recommending loans (being paid by the lenders).
Work Out What Kind of Loan You Need First
I find it’s easy to narrow down the options first. Do you need a residential or investment loan?
Need to Borrow More than 80% Loan to Value Ratio?
Do you need to borrow more than 80% of the property’s value (LVR)?
Property Value $500,000 = LVR 80%
Deposit Required $100,000 + Borrowing costs ~ 6% property value 30,000 = $130,000
If you work in an occupation considered at super low risk of default, you may be able to get lenders mortgage insurance (LMI) waived.
Different lenders have different eligibility criteria. Accountants, lawyers, judges, doctors, dentists, vets, optometrists, chiropractors and physiotherapists. Nurses may be able to get LMI waived up to 85% loan to value ratio, or discount LMI.
Borrowing over 80% LVR is a higher risk strategy but can suit those trying to get into a rapidly rising property market and investors.
Do you Need a Redraw or Offset?
In these articles, I go through the benefits and downsides of offset accounts and redraw facilities. They are both ways to potentially reduce interest paid. You will have to pay extra in fees (particularly for offset accounts). If you will keep more than ~ $20,000 in savings it is likely worthwhile paying for an offset. The higher interest rates go, the less you need to have in savings to make offsets worthwhile. They are ideal for emergency funds, and as discussed in the articles above.
How Much Will You Borrow?
Please work this out based on the repayments you are happy to make on a monthly basis.
Then check you can borrow that amount with an online calculator.
If you calculate your maximum borrowing capacity first, you will be psychologically anchored to that (usually) higher price.
Mortgage repayments can be significant dampeners of your ideal lifestyle if you over commit yourself. If you want to buy as much house as you can possibly afford as part of a financial plan, make absolutely sure you are buying the right house. And make sure you are happy to make the sacrifices involved in that strategy.
Remember to price in extra insurance needed such as income protection, TPD and life insurance premiums. Unfortunately, these have become far more expensive over the last couple of years, even for those of us with no longer available “level” premiums.
Do You Want Fixed or Variable Rates?
This may come down to the actual rates on offer at the time, so I don’t think this needs to be set in stone before looking at options.
Fixed rates are offered over 1-3 years (and longer, but often at great expense). The bank sets these rates based on all the information available to them. They set these rates to attract customers, whilst obviously maintaining their own profits. Fixed rates are usually a little more expensive than variable rates, although this trend has been reversed recently.
The Reserve Bank of Australia (RBA) review the official cash rate monthly and increase or lower it to manipulate the economy as close to a happy steady state as possible. The banks choose to pass these changes on or not, even increasing rates independently, to maintain profit levels.
Despite this over the long term, variable rates have usually been cheaper than fixed rates. More than half of borrowers who sign up for a fixed rate end up paying more than they would have with variable rates.
People choose fixed rates because they:
- Believe they can predict interest rate moves (and think they will increase)
- Have borrowed a lot of money and would struggle to meet repayments if interest rates increased
We were nervous buyers in 2008, on unimpressive salaries at the time. I’m grateful our mortgage broker at the time talked us out of fixing rates then! I think our rate was ~ 8% at the start!
A fixed-rate usually locks you into the loan for a period of 1-3 years, with an exit fee to break the agreement. This provides inflexibility in the case circumstances change, you wish to move or refinance to access equity.
Fixed-rate mortgages also don’t traditionally allow offset accounts. There have recently been mortgages offered with fixed rates and offsets, but to go with these options you will be limited to a handful of loan choices.
It is possible to hedge your bets by fixing part of the loan and keeping another part variable. This can offer the best of both worlds for some. They have more security around repayment amounts but are able to offset emergency savings and future surplus income against the variable portion of the loan.
Our mortgage broker did not talk us out of fixing rates after our most recent investments property purchase. With rates so low, it’s hard to imagine them going much lower. Fixed rates have been offered by lenders at rates lower than variable rates. We ended up going with a mixture of variable and fixed rates for our mortgages.
One-off fees are less significant than recurring annual fees. Add the annual fees to the interest payable on the amount borrowed to compare mortgages like with like.
Similarly “cash back” or airline point offers may be lenders trying to distract you from fees and interest payable during the life of the loan. It is the recurring expenses that are most significant.
Compare mortgages over 3-5 years. You should review your lender options 3-5 yearly, and will likely refinance to better options at the time. If you are fixing for a period, compare rates for the fixed period only. You will need to review the loan and compare it with competitors at the end of the fixed rate.
Comparing Interest Rates & the Comparison Rate
I tend to ignore honeymoon low-interest rates, which tend to balloon after 1-2 years. I don’t want to refinance my borrowings after a year. It’s a lot of hassle. I would rather secure a good value loan for 3-5 years (or the fixed-rate term) and not have to worry about it for a while.
What is Mortgage Comparison Rate?
Due to the complexity of loan offerings available, legislation has been introduced to attempt to make it easier. Each loan has to display a “comparison rate” in its advertisement. The idea is that the comparison rate lumps all fees and the interest payable for a loan together so that you can compare like with like.
Unfortunately, I don’t think a comparison rate is that useful for most of us. In fact, they may provide you will very inaccurate information based on your situation.
The comparison rate is based on a standard borrowing scenario – the rates and fees incurrable by a $150,000 loan, repaid over 25 years.
I don’t know anyone who has brought home for $150,000. And most home loans are over 30 years. Most financially savvy households will refinance their loans 3-5 yearly anyway.
A $395 annual package fee is usually the same whether a home loan is for $150,000 or $1,000,000! The interest on the larger loan will be a far more significant part of the equation.
If you are (conveniently) borrowing just $150,000 the comparison rate will be an excellent comparison tool. For the rest of us, we need to do the maths ourselves or ask our mortgage broker for a detailed comparison based on our actual intended borrowings.
Is Flexibility Important?
Life is unpredictable and personal circumstances can change quickly, and dramatically.
It is worth taking some time to consider how important flexibility is in your situation. If you are planning to stay put in a home for 10+ years, with no plans to invest and a low likelihood of needing to move flexibility can be a low priority.
For those with more options on the horizon, avoiding loan discharge fees and prolonged fixed rates are a good idea.
Utilising an offset account instead of a redraw facility will mean extra repayments can be moved to a new home if you end up converting the old one to an investment property. If you pay off the loan (using a redraw) you cannot withdraw to gain access to tax deductibility.
Take your time making the right choice of property and loan. Remember these are some of the biggest financial decisions of your life. Get it right!
Have you recently taken on a new mortgage or refinanced. Comment below to tell us what kind of mortgage you went with and why.
Your wealth accumulation journey starts as soon as you make the first step.
Aussie Doc Freedom is not a financial adviser and does not offer any advice. Information on this website is purely a description of my experiences and learning. Please check with your independent financial adviser or accountant before making any changes.