If you’re looking to borrow, whether it be the first time or not, the options and jargon can be overwhelming so we’re break it right down for you in one easy to digest glossary of terms.
Loan to Value Ratio (LVR)
LVR is one of the fundamentals of borrowing and it represents the amount of your loan versus the value of your property. For example if you buy a property for $500,000 and you borrow $400,000 then your LVR is 80%.
80% is considered the norm, meaning you need to come up with the 20% deposit plus funds to cover stamp duty if applicable. You can borrow over 80% of the property value though you’ll likely need to pay LMI (see below).
LVR can also have an impact on the cost of your loan, as when the LVR is over 80% you’ll generally pay a higher APR (again, see below) whilst with some lenders you’ll also get a better APR as the LVR goes down below say 70% or even more below 60% and so on.
This is the first thing a bank will look at, if your LVR isn’t appropriate, or LMI not affordable they will not consider your application.
Annual Percentage Rate (APR)
APR is the annual amount of interest you pay on your loan, calculated as an annual percentage of your outstanding balance, and is clearly a very important part of what your home will actually cost you. When banks say there interest rate is for example 2.5% this is their APR.
It’s important to note that most of the time you’ll be repaying both principal and interest, so your total annual repayment will be more than just your annual interest cost. More to come on this below when looking at different rate types.
Owner Occupied (OO) vs Investment loan
One of the main classifications of loan type is OO vs investment. In reality all features are largely the same, with investment loans carrying a higher APR. In general, an investment variable rate for example will be about 0.2% more expensive than the OO loan.
Principal and Interest (P&I) vs Interest Only (IO) repayments
Whilst repaying both the principal and interest on a loan is most common, there is sometimes an option to pay only the interest for a period of time, generally 1 - 5 years.
When repaying P&I you will repay the loan in equal monthly amounts over it’s term, most commonly 30 years for a standard home loan. Whilst repayments are equal the reality is that you’re repaying mainly interest at the start, and mainly principal towards the end as the interest cost reduces as your principal balance reduces.
When paying IO, you aren’t repaying any of the amount you borrowed, only the interest you’re being charged on that amount so you loan balance will not reduce.
A few things to keep in mind when considering interest only;
If your LVR is over 80% it’s highly unlikely that you’ll be allowed to pay interest only
Interest only APR’s are always more expensive that P&I, often by about 0.5%
As the principal balance of the loan is not reducing when paying IO, the balance of the loan that you’re paying interest on is higher, so not only is the APR higher but the balance interest is paid on is higher
As you’re not repaying principal when paying IO, you aren’t building equity in your property other than any potential capital growth
Variable vs Fixed rates
You have the choice to make your APR fixed or variable, or split your loan to have a combination of both.
A fixed rate means for the period you select, generally 1 - 5 years, the interest rate will not change when the RBA changes the official cash rate or banks independently move their rates. Also keep in mind that especially when the cash rate decreases, banks are not obligated to pass any or all of that decrease onto borrowers, however they most often do as borrowers are likely to change banks if not.
Under a variable rate your APR may change at any time as banks change their variable interest rate.
At the time of writing this article, in a historically low interest rate environment, fixed rates are commonly lower than variable rates which is against the norm. This means that you will save on interest expense by fixing your loan. More commonly fixed rates are higher than variable rates, so the reason for fixing at a higher cost would be purely to protect yourself against rising variable rates in an environment where rates are expected to go up.
Some important things to note when considering fixed rates;
Fixed rates are much more restrictive, meaning you generally can’t make significant additional repayments (often capped at $10,000 per annum), have no ability to redraw prepaid funds and can’t have an offset account
If you need to break a fixed rate loan, i.e. to sell the property, there is a break cost applicable which is a calculation based on loan amount, how far through your fixed term you are and interest rate movements between when you locked your rate in and the time you wish to break the loan
Generally, if you wish to have the flexibility to sell your property, make additional repayments or wish to have an offset account to leverage savings from surplus cash then a flexible rate loan or at least a flexible portion would be more suitable.
Lenders Mortgage Insurance (LMI)
LMI needs to be paid in the majority of cases where your LVR is greater than 80%. There are many LMI calculators available online though it can be a material impact essentially when considered alongside the need to also pay stamp duty.
It can be capitalised on top of the loan, meaning that you borrow the money to pay for it, however this will push the LVR higher again, possibly to the point where the LVR goes over 95% and banks will not approve your application. As the LVR goes up, the cost of the LMI also increases.
A point to note is that for LMI applications over 90% LVR in most cases banks require 5% genuine savings in that they require evidence that applicants have saved 5% of the property cost. This will be done by reviewing bank statements to ensure ability to save, opposed to the 5% being a gift for example.
Pre-approval
If you’re looking to purchase a property and seeking an indication that you’ll be eligible for finance you would seek a pre-approval or what can sometimes be termed conditional approval or approval in principle. This occurs prior to you finding the actual property that would be purchased and then act as security for the loan.
Once you find a property and agree to terms, the bank would then value the property to ensure that market value paid is reasonable and also that it fits within their acceptable security requirements. Banks will at this point often require some refreshed financial information to ensure that financial circumstances have not changed since granting the pre-approval.
Pre-approvals are often valid for 3 months (6 months in non-COVID times) at which point they will need to be refreshed.
Stamp Duty
For the large majority of property purchases in Australia buyers need to pay stamp duty. The amount applicable changes state to state and you should use the official government calculator for the state in question.
The most common instance where stamp duty is not applicable is for first home buyers, and is dependent on the value of the property being purchased. In NSW for example and at the time of writing, stamp duty becomes partly applicable when purchasing a property over $650,000, and applicable in full when buying for over $800,000.
Stamp duty is a significant cost of becoming a homeowner and is often really restrictive especially considering most commonly you also need to save a 20% deposit.
Offset Account
An offset account is a feature that comes with certain types of home loans, often on premium products that involve a fee or at a higher APR.
They offer a brilliant interest saving device in that any surplus cash held against a loan is offset with interest not being paid on the loan for any funds that are held in offset.
For example, if you have a $100,000 loan, and an offset account with $10,000 sitting in it, you would only pay loan interest on $90,000.
It’s common that any cost associated with having an offset account is outweighed by the savings received via the funds in the offset account, and your broker can help you to understand the numbers applicable to your scenario to know if it’s a worthwhile cost.
Redraw
Redraw means that you can withdraw from your loan any additional funds you have paid above and beyond your minimum repayments. Generally, if you have repaid additional funds you can simply redraw these via your internet banking.
By paying additional funds off your home loan you are reducing your loan balance and therefore your interest cost, and with a redraw feature you have the ability to leverage this interest saving whilst still having full access to your funds.
Redraw features are all but standard on all variable loans these days, however if this is a requirement of yours be sure to double check availability.
Application Requirements
The list of information required by banks can be a long one and depends on the type of borrower, i.e. if you’re a PAYG employee or self employed.
The minimum requirement for a PAYG application is;
100 points of ID, generally being licence and passport
Payslips
Tax returns
Bank and other loan statements
For self employed applicants you can add;
Business financial statements
Business tax returns and possibly BAS’s
There are also other factors that may increase the requirements such as;
Rental statements if you have investment properties
Super information for older applicants
Proof of deposit for purchases
Genuine savings for LMI applications
Affordability assessment
When assessing a loan one of the key things a bank looks at is the applicant's ability to meet repayments, with consideration for many things including interest rates increases.
The first thing they look at is income, whether it be from PAYG employment, self employment, or investments.
The next thing they’re interested in are your ongoing expenses which they tend to look at very closely. You will be required to list individually all costs in your life. If your expenses seem overly low banks will apply what is known as the Household Expenditure Method (HEM) which is based on the makeup of your family unit, applied as a minimum expense threshold and is part of their responsible lending obligations.
Finally, they calculate the cost of any new or existing debt you will have. As a risk measure for general changes to financial circumstances and for potential increases in interest rates, they calculate your debts based on an affordability rate which is significantly higher than your actual APR. For example many lenders will apply an APR of around 6% which for a $500,000 is around $17,500 in additional annual interest above a standard actual APR of 2.5%. This clearly has a large impact on affordability assessment and is something borrowers need to be aware of.
Another thing that often trips the affordability assessment is how banks view rental income from investment properties. It is common that banks will only count around 70% of rental income to allow for associated costs and potential vacancy.
First Home Buyers Grant & Assistance Scheme
Whilst a bit of a moving beast in that these schemes change regularly, all first home buyers should be aware of any potential benefit they can receive from either state or federal Government.
At time of writing the FBHG really only applies to new builds or new home, although the FHBAS can allow for stamp duty exemptions as mentioned above. The most up to date information, using NSW as an example, can be found here.
Construction Finance
If you’re looking to buy land and construct, there are options available to you under specialised loan schemes covered by most major lenders. For more information visit the blog post land and construction finance 101.
