This is the 2nd edition of our 4-part series ‘First steps for First home buyers’. In case you missed it, check out the previous part, “Part 1: Saving Up”, where we discuss the first, and often most tedious step of your home buying pathway.
Taking out a Home Loan
You’ve crunched the numbers, stacked up a decent amount of savings and are rearing to get into your first home. Unless this stack is worth several hundreds of thousands of dollars, the next step for you is probably to take out a home loan.
What is a mortgage?
First off – what is a mortgage? Is it this the same thing as a home loan? Can we use these terms interchangeably? Hell, we’ve already done it twice in just 2 paragraphs. While not the same thing, home loans and mortgages work hand in hand.
A home loan is the actual money exchanging hands between yourself and the lender (i.e. how much is lent to you). Meanwhile, mortgages are the legal document that shows your obligation to repay your debt to the lender when you take out a home loan. With mortgages, your property serves as collateral, meaning that lenders have the right to foreclose on your property if you don’t pay the remaining debt on time. This is what makes mortgages a ‘secured instrument’.
Mortgages can be any period of up to 30 years. Generally, the shorter the period – the higher the loan repayments but the lower the total interest payable. Once your home loan is repaid, you fully own the property and the mortgage is gone.
Process of applying for a mortgage:
- Calculate your deposit
- Research the home loan that best suits you
- Apply for a loan
- Calculate your borrowing capacity
- Formal approval and settlement
Calculate your deposit
As discussed in the first part of our ‘First steps for first home buyers’ series, the amount you’ve saved for your deposit will influence your borrowing capacity, and whether or not you’ll need to pay the additional lenders mortgage insurance (LMI).
What types of loans are available?
Think about the process of finding the perfect pair of jeans. You jump from store to store until you find the one – the one that’s the right shade of blue, the perfect snugness and the right cut above the ankle, all at a reasonable price. Choosing the right home loan for you requires a similar, if not more extensive process of window shopping to compare features, interest rates and fees across different home loan providers. The best way to do this is to ask for a key facts sheet from different lenders. This sheet contains all the key features of a loan including the amount, term, interest type and an estimate of the total repayment amount (including the loan amount and fees). Below, we’ll discuss some of the different types of loans available.
[ASIC’s MoneySmart recommends being wary of companies that claim to help you pay off your mortgage faster.]
This research and comparison process can be done either by yours truly or by a mortgage broker; i.e. a professional home loan window shopper. They assist with the home loan selection process, provide you with a shortlist of recommendations and offer guidance in navigating the home-buying processes and jargon. Their services are usually free, being paid a commission by the lender.
Principal and Interest Loans
This is the most common type of loan and involves making regular principal payments to pay off the amount you have borrowed, as well as additional interest. This type of loan is typically repaid over the life of a loan.
A lender might offer you additional features on a principal and interest loan such as a redraw facility or offset amount. While these additional features are attractive at first glance, they sometimes increase the cost of the loan, meaning lenders will charge a higher interest rate. The higher interest rate may erode the costs you may save on an offset account, for example.
This allows buyers to pay the interest-only for a fixed period of time. This may cost you more over time because the principal amount you borrowed doesn’t reduce unless you choose to make extra repayments. Interest-only loans are commonly taken out by property investors with higher interest payments to take advantage of tax benefits such as negative gearing. In addition, they often plan to repay the principal when they resell their property to realise capital gains.
Lenders will often offer the following interest rate options for your home loan:
- Fixed rate: the rate remains unchanged for a fixed period, before reverting to a variable rate. You can typically choose a fixed period of between 1 to 5 years. While this option gives you certainty about the amount you’ll pay, you won’t be able to reduce or increase repayments as you need without facing some lofty fees.
- Variable rate: while offering more flexibility in terms of making extra repayments, the variable rate can increase/decrease at any time – often depending on the RBA cash rate.
- Split loan: part of your loan is variable and the other part is fixed.
Note: the Australian Prudential Regulation Authority (APRA) has urged lenders to take closer consideration of your ‘serviceability’- your ability to afford repayments on a loan. Beyond the usual checks to ensure that you can make repayments in current economic conditions, APRA also urges lenders to add a ‘home loan serviceability buffer’. This is usually a 2-3% added to their usual assessment to determine if you could still afford the loan if interest rates were to rise in the future. However, with the latest RBA rate drops, APRA has also relaxed their serviceability assessments.
Calculating your borrowing capacity
Pre-approval, also known as conditional approval, is a lender’s estimate of how much you can borrow based on your income, assets and liabilities. Thus, before approaching any lenders, it’s helpful to have the following documentation organised and ready to go:
- Identification documents: 100 points of ID required (2 primary documents or 1 primary and 2+ secondary documents)
- Proof of income documents: recent payslips stating YTD income or the last financial year’s notice of assessment from the ATO. If you have multiple sources of income (e.g. rental, shares, Centrelink), you’ll need to provide documentation for each.
- Asset and liability documents: documentation for any vehicles, term deposits or other properties owned and outstanding debts or ongoing payments for products like loans and credit cards.
This step gives you an indication of your borrowing power and helps you establish a ballpark budget. You could also ask your lender to provide you with an automated valuation report to give yourself and the lender a better idea of your purchasing range. Pre-approval isn’t a binding agreement – it’s more of a thumbs up from the bank to look for appropriate houses in their estimated range and may allow you to move faster in the final steps of offer acceptance. You can also estimate your borrowing power before approaching lenders by using the home loan calculators and tools available on most bank websites.
The loan approval process
Once you have applied for a suitable home loan and gotten pre-approval, it’s onto you to pick out your first home! Keep an eye out for the next article in this series for more on selecting the right property.
Once you’ve put down a deposit for the property you’d like to buy and undergone the exchange of contracts, your home loan will move towards full, or ‘unconditional approval’. To reach this point, you’ll need to provide the lender with a copy of the signed contract of sale as well as any other documents that may be required for final credit checks.
Settlement occurs around 6 weeks from the exchange of contracts upon which the loaned funds will be transferred to the vendor. From this date, the keys are yours and the exciting journey of homeownership (and less exciting loan repayments) finally begins!
Next up in the First steps for First home buyers series – Part 3: Selecting the property. Here, we talk about the pros and cons of different property types. House or apartment? Read and find out!