How do home loans work?

There are so many aspects of the home loan process that you’ll have to work through and consider, which is why this guide to how home loans work will give you the rundown on everything you’ll need to know. Read on to find out more. 

What is a home loan and how does it work?

A home loan, or mortgage, is a type of loan where a financial institution such as a bank lends you funds to purchase a property. This serves as an advance on funds for a borrower, who will then repay the amount borrowed with added interest and fees. Usually, the repayment term on home loans will last 30 years, meaning that it’s an important decision to get right in the first place.

Home loans exist because very few people can purchase a property up front and in full; as we know, property is quite expensive in Australia. Therefore, mortgages are utilised to ensure that most of the population have a fair shot at owning property, rather than a select few.

How do home loan interest rates work?

Interest is a cost added onto each home loan repayment that borrowers have to pay. This is essentially a fee that lenders charge you for borrowing money from them, which serves as incentive for them to grant you large sums of money despite the perceived risk of doing so. The interest on your home loan will be calculated on the daily balance of your loan without payments. For instance, if your balance was $200,000 and your interest rate was 5%, your daily interest would be $27.39 for the day.

Interest rates will fluctuate with market movement, but your own financial situation will have an impact on the rate your lender is willing to offer you. For example, if you have an exemplary credit history, you’d be more likely to be approved compared to someone whose credit rating is just okay and would likely be offered a lower interest rate as a result. Meeting certain credit criteria plays a large part in determining interest rates.

Which comparison points should I assess when looking for a home loan?

Fortunately, prospective borrowers aren’t short on areas to compare between loans. Savvy is a great place to start, as our financial comparison tools help you contrast and compare home loans and lenders in the areas most important to you. Here are some of the most important aspects of a home loan you should compare:

Interest rate

As discussed above, interest rates come in all shapes and sizes. What that means is that you have to put in the hard work to find one that works for you and doesn’t cost you thousands of dollars more than other options. Interest rates are easy to compare, as they’ll always be easy to find on lender sites. However, what you have to bear in mind is that even a seemingly insignificant disparity in interest rates can be the difference between you saving or spending big, as this table illustrates. The following estimates are based on a $500,000 loan repaid over a 30-year period:

Interest rate Total amount repaid Money saved
3.0%
$758,887.26
N/A
2.75%
$734,834.13
$24,053.13
2.5%
$711,217.62
$47,669.64

*Estimates don’t include fees

Fees and comparison rates

The sleeping giant of home loans, these can rear their ugly head and set you back thousands if you’re not careful. You’ll always be able to gain an understanding of what you’ll be paying in fees through a lender’s comparison rate. Watch out in particular for one-off payments like property valuation, conveyancing and discharge fees, while you can potentially reduce your fee bill by hundreds or thousands of dollars when it comes to your monthly or annual fees and application fee. You can see how fees can make a difference to what you’ll be paying for your home loan in the simplified table below. Using an initial interest rate of 3%, we can work out the following:

Application fee Monthly fees Discharge fee Total fees paid Comparison rate Total amount repaid
$0
$0
$0
$0
3%
$758,887.26
$500
$10
$300
$3900
$300
$763,749.79
$1,000
$20
$500
$8700
3.09%
$767,652.20

It may not seem like much, but every cent counts when you’re paying off a home loan. While you’re unlikely to avoid paying any fees at all, something as simple as negotiating your monthly repayment fees down could save you thousands of dollars over the course of your loan.

Loan features

Most lenders will have loans that contain built-in features to draw you to their product. These will often come in the form of additions to your loan that add to the overall flexibility of your repayment cycle. Some of these may include:

  • Additional repayments: many lenders, particularly in the fixed rate home loan market, will charge you a fee for making an extra repayment. This is less common in variable rate home loans, but it’s definitely something you should look at to pay your home loan off more quickly and save on interest.
 
  • Offset accounts: want to make more additional but not have to pay interest on them? An offset account is the feature for you! This account allows you to make extra contributions to your principal total but your lender won’t charge you interest on it.
 
  • Redraw facilities: this feature allows you to access additional repayments that you’ve made throughout your loan and take funds back from them. It can be useful to have these at your disposal to cover yourself for any unexpected costs like bills.

How do the different types of home loans work?

One of the most important aspects of a home loan that shapes your repayment experience is the way you choose to structure your interest rate: lenders will give you the choice of a fixed, variable or split interest rate.

Interest rate How it can help you How it can hinder you
Fixed rate
Locking a good interest rate in can be a huge boon to borrowers who value stability when it comes to knowing what you’re paying. This type of loan protects you from any interest rate drops and ensures that more accurate budgeting into the future is able to be achieved.
The double-edged nature of protecting against interest rate rises means that you’re also prevented from enjoying any drops in the market, which could potentially cost you plenty in the long run. Fixed rate home loans are also known for their stricter nature regarding fees, so you’ll likely be slugged for trying to break your loan early or make an additional repayment.
Variable rate
The problems that fixed rate home loans face with their inflexibility don’t affect variable rate loans. Additional repayments are, more often than not, able to be made free of charge, while switching loans is generally less of a hassle. Also, any drops in interest rates will help your back pocket. This type of loan often costs borrowers less in interest over the repayment period.
Once again, leaving yourself open to rate drops also means you’re vulnerable to rate rises. However, the main area to factor in is the potential for inconsistent repayment amounts, which can limit the accuracy of any budgeting you might be able to do ahead of time.
Split rate
If you can’t decide between the two, you can choose to opt for both at the same time! Borrowers can enjoy the flexibility afforded to them in determining how the split is weighted (e.g., 50/50 or 75/25) and through its variable elements, while also adding security to your payments in knowing how much interest you’ll be paying.
Split rate loans essentially divide your home loan into two, which means you’re paying (different) interest rates and fees on each account. Getting your split wrong, such as signing up for an interest rate that drops shortly after, can cost you quite a bit of money, and switching your split rate loan could be more difficult to do without having to pay a costly break fee.

Explained: home loan terminology

This glossary will help you understand the different terminology used in the home loan and mortgage industry.

Conditional Approval: In essence, conditional approval is the same as pre-approval. It means the lender has agreed to the loan in principle and you can begin to look for a property.

Conveyancer: A legal professional who prepares and lodges necessary documents and contracts throughout the purchasing process, particularly dealing with the transfer of title between the previous and new owners.

Loan-to-value Ratio (LVR): This is the amount that you actually need to borrow, by working out the value of the property minus your deposit.

Maximum Loan Amount: The largest amount that your chosen lender will actually loan to you.

Mortgage: Another name for a home loan, which also refers to the fact that your lender is using your property as security against the loan.

Principal: The principal is the amount that you owe on your home loan.

Settlement: Settlement is the process whereby the ownership of the property is transferred to the buyer. It will involve a contract of sale and transferring the certificate of title.

Stamp Duty: A tax that you’ll need to pay when you do buy a home. Stamp duty amounts vary from state and territory, and also depend on how much you pay for the property.

Valuation: The process of assessing the value of a property.

How does the home loan application process work?

Take a look at the process of applying for a home loan so you can gain a greater understanding of what you’ll need.

Top tips for maximising your chances of home loan approval

We’ve put together some top tips to make your home loan application experience a little easier.

The more research, the better

That goes for due diligence on lenders, more information on your own financial situation and an exceptional understanding of the properties and area that you’re interested in.

Pay off as many debts as you can in advance

This will improve your credit score, which will in turn increase your chances of being considered a reliable borrower. 

Look out for your credit card limits

Lenders will actually include the whole limit in their debt and income assessment, not just the amounts owing.

Always have a safety net

Saving a little extra on top of your deposit is always recommended, just in case any unforeseen expenses pop up.

Increase your deposit size

The bigger the deposit, the less risk the lender will see the home loan as. 

Don’t bombard several lenders at once

Lenders will be able to see when you’ve applied for a loan with other institutions on your credit report, which doesn’t look great.

Don’t change jobs

If you’ve re-entered a probationary period at a new job, lenders will probably be put off by the lack of permanency.

Common questions about home loans and how they work

The process of understanding and applying for a home loan raises so many questions. We’ve answered the big ones above, but these are some of the other small, common FAQ’s.

How do I know when to apply for a home loan?

You should only apply for a home loan when you have ample deposit and meet all of the criteria stipulated by your lender. There’s no such thing as too much preparation and research when it comes to preparing to apply. Financial comparison websites like Savvy provide detailed information on a wide range of loans, including fantastic comparisons of different home loan lenders.

Can I get a home loan if I’m self-employed?

Yes – however, as a self-employed person, you will need to provide more documentation to a lender. That will include two or more years of tax returns, as well as correspondence from your accountant. If you don’t have as much access to documents as a lender would like, you can apply for a low doc home loan. For more information, check out our page on self-employed home loans.

Can I get the First Home Owner Grant for my home loan?

Yes – the answer to this question will vary from state to state and on your own personal situation, but if you are purchasing your first property and meet the conditions of your state government, you’ll be able to obtain the First Home Owner Grant.

What is a deposit bond?

A deposit bond is usually issued by an insurance company and are used instead of cash to pay a deposit when buying a home. This can make it easier for people to buy a property, if they don’t have ready cash for the deposit.

How does eligibility for a mortgage work?

The factors that will determine your eligibility for a home loan include your income, employment, credit score, debt-to-income ratio and the money you have saved for a deposit. You’ll also need to be 18 years or older to apply, and a permanent resident of Australia. Once you’ve done some research on the requirements of the loan and whether or not you can successfully apply and then make the repayments, you can begin contact your preferred lender.

How much do I need for a home loan deposit?

Many lenders require a deposit of 20%. For a loan of $400,000, that equates to $80,000 in savings. However, some lenders will accept a deposit of less than 20%, going as low as a 5% deposit. Saving a deposit can be the hardest part of buying a home, but there are ways to apply with a lesser amount. You do however need to be aware of the potential ramifications of doing so.

What is Lender’s Mortgage Insurance?

Lender’s Mortgage Insurance, or LMI, is insurance that protects the lender in case a borrower cannot pay back their mortgage. It can be either paid up front or included in the loan and paid off over time. LMI is required when borrowers have a deposit below 20%, as it provides assurance to the lender that the money will be recouped if the borrower defaults and cannot pay back their home loan. However, seeking a guarantor for your home loan can help you avoid having to pay for LMI.