What type of loan is best for you?

When choosing your loan, there are a number of various features which you need to get your head around. Additionally, there are some fundamental aspects relating to the nature of the loan itself which you need to be aware of. This guide should give you a good basis for deciding which type of loan to choose.

How important is the interest rate?

The interest rate component of a loan is quite possibly the most important aspect of the loan itself. The interest rate will determine what your repayments will be and subsequently how long it will take you to pay off the principal of the loan. Many astute borrowers look at the Annual Average Percentage Rate (AAPR) rather than the promoted 'interest rate. What's the difference? Well, the AAPR - also known as the comparison rate or true rate - shows the true costs of a loan by taking into account all of the other costs and fees (which we will discuss later). For example, Bank A may offer a lower interest rate on a loan than Bank B, however Bank A charges a monthly administration fee whereas Bank B does not. If we add this monthly charge to our interest payments, we may find that the AAPR of Bank A is actually higher than Bank B. This highlights the effectiveness of using the AAPR! Key point - read between the lines and find out all the additional costs. Only this way will you be able to compare the true cost of the loan!

Principal versus deposit?

The principal amount of the loan is the initial amount of money you need to borrow from the lender. For example, if you want to buy a house worth $200,000 and you have saved $50,000 which you can put towards the house, you will need to borrow $150,000 to purchase the house, right? The $150,000 is therefore the amount you owe the lender - the principal. The $50,000 you put towards the house is the deposit. Importantly, banks make money on charging interest and fees on 'the principal'. Therefore, the value of the principal will have a significant effect on your repayment obligations.

Fees and Costs

When buying a home, there are a number of fees you need to pay, not just to your home loan provider. The main fees charged are:

  • Stamp duty - This fee varies from state to state and is dependant on the value of the property you are purchasing.
  • Government fees - Various government fees will apply including a land transfer registration fee as well as other flat and variable (dependant on the purchase price of the property) government taxes.
  • Mortgage Protection insurance - This cost is incurred as protection for the borrower in the case of death, disability or retrenchment. Effectively, it covers the borrowers repayment obligations if the borrower is unable to make the repayments.

Other fees include legal fees, building inspection fees, moving costs, not to mention utility connection costs. All of these add up and need to be considered when making that property purchase.

Fixed or Variable interest rate?

The benefits of variable versus fixed loans depend on the future trend in interest rates. Basically, you will be better off locking in a fixed rate now if interest rates go up in the future and vice versa if rates go down. So... how do we know what interest rates will do? Well, we don't know for sure but it's best to find out what the experts say. Read the business pages of your local newspaper or search the internet and try to find out what the experts are predicting. Some borrowers like to hedge their bets and opt for a mixture of both fixed and variable. Finally, find out what the options are on each of these differing rates? For example, how long can you lock in fixed rates for? You lender should be able to provide you with this information before you make your choice.

Other variable features to be aware of

Other offerings that are marketed by lenders are short term 'sweetener' deals. These work by offering the borrower a lower rate of interest in the short-term. Borrowers need to weigh up the benefits of these deals with the repercussions of the fall back 'default rate'. The most common of these is referred to as a a honeymoon rate. A honeymoon rate is where the lender offers a lower rate of interest for the first one to two years. Be wary, the lenders often make back their margins (and more) by charging a higher than average rate after the 'honeymoon' is over!

Bridging Loan

If you are having trouble borrowing money to buy your dream property due to timing problems i.e. you are required to pay for the new property before you sell your existing property, you may be eligible for a bridging loan. Generally bridging loans offer a similar interest rate to standard loans and are used to offer you short term finance in order to 'bridge' the timing difference between purchasing property and selling your own property.

Line of Credit home loans

In a similar fashion to a standard overdraft facility, a line of credit offers the borrower the option to draw down money from the lender against the equity in the property. These are particularly beneficial for those borrowers who already have a significant amount of equity in the property. However, the downside of this flexibility is that the lender will usually charge a higher rate of interest.

Home Equity Loan

Similar to a line of credit loan, an equity home loan is a type of loan which allows the borrower to use the equity in their home as collateral. These loans are not necessarily easy to source as a very high credit rating and a substantial amount of existing equity are required. However, the benefit of these loans is that your home equity can be used to fund home repairs or extensions and hence add further 'equity' to the value of your home!

Professional packages

Professional packages are loans generally made to people who are borrowing larger amounts of money (higher-value clients). The lenders will offer them a discount on the interest rate in order to capture the business of the wealthy individual. In addition, the lender may offer other perks such as offset accounts, redraw facilities, reduced fees, lower premiums on insurance products, to name but a few. As competition has increased amongst lenders, these professional packages have become more readily available to lower value clients (so long as you are willing to commit to a credit card and transaction account with the same lender!). However, if you don't need all the extras and you end up being locked into a high interest credit card by the lender, you may be better served looking around for other types of loans.

Deposit Guarantee Bond

In many ways, a deposit guarantee is similar to bridging finance in that it provides the necessary funds to the borrower in the time between purchase of the new property, and sale of an existing property. Specifically, these types of loans are used for funding the deposit which is required at the time of purchase when contracts are exchanged. Borrowers are assured that these funds will be available at the time of contract exchange due to the 'guaranteed' nature of the fund.

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Published on March 3-th, 2008 in Home Loans
Damon Rasheed is the CEO of Rate Detective, an Australian financial service comparison sites specialising in Life Insurance, Income Protection Insurance and home loans. Damon holds a Master's Degree in Economics from the University of Melbourne and has been involved in many start-up internet businesses.
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Not all providers in the market are included in the comparison.

Any information or advice contained on this website is general in nature and has been prepared without taking into account your objectives, financial situation or needs.