Home Loan Terminology Explained Simply

Terms you will likely hear when financing your build
Landconnect — 08 March 2020

Is it your first time buying a new home? If so, you may start to feel overwhelmed by the terminology being thrown around by family and friends. Do not worry; you are not alone! The world of banking can be difficult to navigate, and all that jargon can leave your brain feeling bamboozled. 



Before you begin the conversation with your bank or broker, this article will bring you up to speed and demystify key terminology to help you feel at ease during your home buying experience.


Interest Rate


When you take a loan, you will be required to pay interest. It's one of the ways that lenders make their profit, so consider interest the fee you pay the lender to borrow money from them. Typically, it's calculated as an annual percentage of the total amount of your loan. This additional charge is added to the amount borrowed and must be repaid in addition to the original loan.


Interest rates will vary and their two typical loan types: Fixed-Rate Loans or Variable-Rate Loan.

 

Fixed-Rate Loan  


As the name suggests, with a fixed-rate loan, the interest rate is 'fixed' at a rate for a specified period. The advantage of fixed-rate home loans are they offer the borrower peace of mind for a predefined period.


Your fixed-rate Loan may lock in the rate for the first 2 to 5 years of your loan, after which it will convert into a variable-rate loan. Then the rates will be subject to market conditions.

The certainty fixed loans provide means you can plan for years to come when you know repayments will not increase. However, it's important to note, if interest rates decrease, you will miss out on taking advantage of lower rates. 

 

Variable Rate Loan


A variable loan is the more common of the two as it offers flexibility. The interest rate will fluctuate throughout the term of the loan. The rise and fall of the rate are closely aligned to the interest rates set by the Reserve Bank of Australia. Variable loans allow you to take advantage of falling interest rates; however, if interest rates increase, then your lender may increase your repayments’ too. This type of uncertainty may make it harder to budget.

 

Other terms you may hear in conversation related to interest rates as follows:


Interest Only


Investors typically use Interest-Only loans; they allow the borrower to temporarily pay only the interest cost of their loan for a predefined period without requiring you to pay down the balance of your loan. After the interest-only period ends, the loan reverts to paying Principle and Interest to pay off the remainder of the debt. 


Pros - The monthly repayments are comparatively lower as you are paying only the interest component on your home loan. This can be appealing to borrowers as lower monthly repayments create positive cash flow to put towards other investments, such as a business or another investment loan. 


Cons - You're going to need to pay the principal of your loan at some point, so Interest Only Loans can make that more difficult by delaying the inevitable. Paying down your loan balance reduces your risk when it comes time to sell. If your property loses value during the interest-only period, then you could end up owing more than the property is worth, possibly requiring you to sell for a loss. 


Principle and Interest 


Most home loans require principal and interest repayments. The principal is the amount of money you have borrowed from the lender, and interest is what the lender charges on top. Your repayment will be divided into these two components, part of your payments the interest on your outstanding loan amount and other to pay off the balance of your loan. 


Introductory rate 


Some lenders may offer an introductory rate, providing the borrower with a discounted interest rate period. The discounted rate is applied at the beginning of your home loan for a predefined period. While these loans are popular, it’s important to note that typically, after the introductory period ends, the loan reverts to a standard variable rate where the interest rate is likely to be higher. 


Basis point 


Basis point, otherwise known as ‘bps’ or ‘bips,’ is a standard measurement unit commonly used to define changes in interest rates. A basis point equals 0.01% interest, and there are one hundred basis points in 1%. 

 

Redraw Facility 


Some loans will offer you a redraw facility. This feature allows you to make extra repayments on your loan, which will reduce the interest payable and the length of the loan. If down the track your financial circumstances unexpectedly change, you will be able to redraw those banked overpayment funds. 

 

Guarantee 


A guarantee is given to the loan provider by a 3rd party on your behalf. Usually this maybe a family member or friend. Once they sign as a guarantor of the loan, they become legally responsible for your loan if you fail to make repayments. 


Equity 


The technical definition of equity can be complicated. Simply, equity is the portion of your new home that belongs to you and not the bank. The value of your property minus the amount you owe on your home loan is your equity! 

 

Settlement 


The settlement is the date in which your purchase becomes finalized, and you take legal possession of your property. Commonly people use solicitors and conveyancers to assist them through the settlement process.


Drawdown date 


This is the date on which you first utilize the home loan! 


Credit report 


Everyone has a credit rating assigned to them. Your credit report contains your financial histories, such as details on your repayments on credit cards and previous loans. Your Lender will assess this report to gauge a clear understanding of your creditworthiness when you apply for a loan. 

 

LVR (Loan to value ratio)


This is simply the amount of money your loan will contribute to the purchase price of your new build.

For example, if you are purchasing an $800,000 home and you have saved $160,000 for your deposit. Your LVR is $640,000 or 80% (800k - 160k)

 

Lenders Mortgage Insurance (LMI) 


In the event your LVR is over 80%, you may be required to have Lenders Mortgage Insurance. This is because an LVR of more than 80% is a higher risk to the Lender.

Lenders Mortgage Insurance is designed as a safety net for your loan provider in the event you default, or there is a valuation shortfall when you sell the property. It will not protect you, only the Lender — the result of having to pay lenders mortgage insurance increase your monthly repayments. However, if you are having difficulty saving 20% of your home loan deposit, paying an LMI can help you enter the property market sooner. 

 

Stamp duty 


Stamp duty is the tax the government applies to property purchases. Few factors go into calculating stamp duty, and each state has its own levy, so it is essential to research what is relevant to your state. Some states offer first-home buyer benefits, which means you’ll pay no stamp duty. You can find more information on Stamp Duty in this article.