Ah, mortgages. There’s a lot of lingo that gets thrown around with home loans. But when entering into a mortgage represents a commitment almost as long-lasting as a marriage, you want to know what you’re signing up for, right?
It could just be the second biggest decision of your life, after all.
Let’s start with the basics. So, what’s a home loan or ‘mortgage’?
A home loan or mortgage is money lent to an individual from a bank to enable them to purchase a property. It’s paid back with interest over a period anywhere between 10-30 years.
Property prices have risen exponentially over the last 30 years, making it pretty rare that anyone but the very richest would have the money to purchase one outright. A home loan effectively comes in to make up the difference between what you have saved or in equity and what you need to buy the property.
There are a lot of different things that go into a home loan, which can make it a bit of a mind field. In this guide we’ll talk you through everything you need to know about mortgages, including:
- Valuation and the Loan to Value Ratio (LVR)
- Lenders’ Mortgage Insurance (LMI)
- The approval process
- Interest rates
- Home loan packages and offset accounts
1. Valuations
A valuation is a detailed report arranged by the lender (the bank) but prepared by an independent, unbiased, accredited valuer to establish a property’s market value.
The bank will use the property as security against the loan and the valuation confirms that they’ll be able to recover their funds through its sale; should you default on your loan and the property needs to be sold to recoup the money they lent you.
A valuation is different to an appraisal, which is just an opinion on the value of the property based on previous sales. A valuation is a certified report on the property’s actual market value, which is why the bank will rely on it when assessing your loan application, rather than the appraisal.
Loan to Value Ratio (LVR)
The valuation is also used to determine your Loan to Valuation Ratio, or LVR for shorts.
The LVR is basically the percentage of the property’s value that your home loan accounts for.
So, say your home is valued at $600,000 and you have a deposit of $120,000. You need to borrow $480,000 – 80% of the home’s value – from the bank to make up the difference. Your LVR is 80%.
Most banks can lend up to 95% of a property’s value, but you want your LVR to be as low as possible. It’s not just a figure you see… your LVR will determine if your loan needs to be covered by Lenders’ Mortgage Insurance and your interest rate. More on that next.
2. Lenders’ Mortgage Insurance
Lenders’ Mortgage Insurance (LMI) is an insurance policy that protects the lender – a.k.a., the bank, not you – if you were to default on your loan.
If you’re unable to keep up with your repayments, the bank may need to sell the property to recover the cost of your loan. If the sale price isn’t enough to cover the outstanding balance, they’ll be left with a shortfall. Not something that flies with banks, so they’ll do everything they can to ensure a potential shortfall is covered.
The cost of this insurance is passed onto you, the borrower. So kind of them, right? It’s added to the balance of your loan to make it more manageable.
The premium is calculated based on the percentage of the property’s value that you’ve borrowed – the LVR we just met above. You’ll likely need to pay LMI if your LVR is more than 80% of the property price and it’s usually tiered from there. So, the bigger your deposit, the lower your LMI will be.
3. The approval Process
Let’s get into the fun part: getting the go ahead on your new home loan!
This often happens in stages. Let’s talk them through.
Provisional approval (a.k.a., pre-approval)
Pre-approval happens when the bank gives you provisional approval for your loan based on an initial assessment. It’s not unconditional, so formal approval is still subject to additional information. It’s not a guarantee.
While it’s not a guarantee, it does help you determine what you should be looking for value-wise in a home. If you’ve got provisional approval for $600,000 for example, you know you should probably skip the viewing of that $750,000 home you’ve had starred.
It also lets you in on the conditions the bank will require you to meet to get that formal approval, so you can work towards them.
Missing information request (MIR)
You’ve found the perfect home and now you need the bank to come good on that provisional loan. Sometimes when we’re trying to move from pre-approval to formal approval, the bank will make a Missing Information Request (MIR) for more information.
This could be things like extra employment information, letters from your employer, tax returns or proof of savings.
Conditional approval
Okay some lenders consider conditional and pre-approval the same thing, and they are similar. Conditional approval happens when your loan is approved subject to specific conditions being met. Unlike an MIR, this could be things the bank needs to provide, like a valuation report.
Unconditional approval
And we’re finally there! Unconditional or ‘formal’ approval happens once the bank has assessed all the information they need and agreed to lend you the funds for your new home.
You’ll be sent contracts to sign and then settlement can be made.
Note: Unconditional approval doesn’t mean the bank can’t reneg on their loan if your financial situation changes, so try not change things up. Read this.
4. Interest rates
Yes, home loans don’t come interest free. But you already knew that.
What you might not know is that there are two types of interest rates to choose from.
Variable interest
A variable rate means your interest will be subject to change over the life of your loan, and whether it increases or decreases is up to your lender. Meaning the Reserve Bank can raise or lower their cash rate but whether it’s passed on to you is still up to your bank.
For this reason, variable loans are more flexible than fixed rate loans, giving you the ability to make additional repayments or payout the loan early with little to no early termination fee.
Fixed interest
A fixed rate means your interest will remain the same throughout the agreed upon term of your loan. It’s usually locked in for a period of 1, 2, 3, 5, 7 or even 10 years.
So, whenever your lender decides to increase or decrease their standard variable interest rate, your rate and repayment won’t be affected. Good or bad.
Your ability to make additional repayments is restricted during a fixed term and if you decide to sell or refinance, the bank will hit you with a fee for breaking your agreement early. Nice.
Once your agreed upon fixed term ends, your loan automatically reverts to a variable rate unless you decide to lock in another.
5. Packages and offsets
Did you know you can bundle your home loan together with your other financial products to save on fees and interests?
Your home loan package can include things like your regular transaction accounts, credit cards, and the one you really want to know about: offset accounts.
Offset accounts
An offset account is an everyday account linked to your home loan. It has much the same features as your everyday transaction account, so you can add and withdraw from it as you would normally.
They do attract a monthly or annual running fee, but sometimes this cost can be covered as part of your annual home loan package fee. Be sure to discuss all options available to you with your financial lender to see which products are suitable for you.
Bonnie’s wrap
There was a lot to cover here but I’m so glad you stayed with us! Mortgages are a kinda big deal, but now you know how they work I hope they seem a lot less daunting. You got this.
Here’s your homework:
If you’re gearing up to apply for a home loan in the not-so-distant future, I want you to read this:
What not to do when you want to apply for home finance.
If you want to get your finances in better shape so you can start working towards that deposit, you need to read this:
How to budget: the five crucial foundations of any savings plan.
