Understanding the different types of home loans available can help you to choose a suitable loan. Lenders have a wide range of home loan products to suit home buyers throughout all life stages - whether you're looking to secure your first home, a home for your growing family or planning or looking to make an investment purchase. That's why it's more important than ever to carefully compare home loan products across lenders.
How to Choose A Home Loan
There are two main features that should be considered when shopping around for a home loan - interest repayment type, and whether it's a fixed or variable interest rate. Beyond that, there are a few optional features to consider including an offset account, redraw facility, and packaged home loans.
1. Look at The Repayment Type
Principal & interest
Principal & interest (P&I) home loans are whereby you pay off both the interest and a portion of the original loan amount. It is the most popular type of home loan repayment in Australia as borrowers build equity into the home over time.
An interest-only (IO) mortgage allows you to make repayments on the interest portion of the loan. While available for both owner occupiers and investors, this option has traditionally been more popular for investors who can claim their interest repayments at tax time. Investors with a fixed-rate mortgage can usually pre-pay their interest in advance for the next financial year, and lower their taxable income for the current financial year. An interest-only loan can also help you manage your cash flow as repayments are usually lower. But you'll still have to repay the principal loan once the interest-only period is over likely resulting in monthly repayments being significantly higher. This is because if you take out a 30 year mortgage, with a two-year interest-only period for example, your principal repayments will then be condensed into the remaining 28 years. Interest-only options vary by lender; some don't offer them at all, some offer only three years, some might offer five, and some might offer up to 10. If the initial IO period is five years and it could be renewable for a further five with some lenders.
2. Look at The Type of Interest Payable
Variable-rate home loans have traditionally been the home loan of choice in Australia. They have been more popular than fixed-rate loans, except for a brief period during the Covid pandemic where fixed-rate loans experienced a strong surge in popularity. The interest you pay on a variable rate home loan may fluctuate with changes to the Reserve Bank of Australia's (RBA) cash rate and other factors. That means if your lender passes the interest rate change onto you, your payments will also change. It's important to remember that while the RBA reviews the official interest rate every month, lenders can independently choose whether or not to increase or decrease the interest rate they charge their customers. Quite often they will increase by a different amount depending on if you're a new or existing customer.
If your interest rate gets higher and you were making more than the minimum repayment yet it has not changed, it could be that your lender has increased the interest portion of your extra repayment and not the principal. This could effectively extend the life of the loan.
With a variable-rate home loan, there are usually no limits on making extra repayments, which means you can choose to pay off your variable rate home loan faster as your financial situation improves.
Fixed rate home loans offer a stable interest rate that's fixed for a set period of time - usually between one and five years. However some lenders offer seven or even 10-year fixed rates. The good news is that a fixed rate home loan makes budgeting easier - you'll know exactly how much your monthly repayments will be for the fixed rate period. You'll also be protected from interest rate rises during that time. With a fixed-rate home loan you won't benefit from interest rate drops, and many fixed rate home loans don't allow you to make extra repayments or may charge a fee for doing so. In addition, historically fixed home loans have attracted higher interest rates than their variable counterparts. When the fixed term expires, you'll likely be placed on the lender's standard variable rate by default, which is usually much higher, which could prompt the need to refinance. You'll also need to be aware of any break fees your lender may impose if you change or pay off your fixed interest loan before the end of the agreed period - this could add up to thousands or even tens of thousands of dollars.
Split Home Loans
While not technically its own product, a split or partially fixed home loan lets you have a foot in both camps. It allows you to set a fixed interest rate on a portion of your loan, while applying a variable interest rate to the remaining balance. This means you effectively have two home loans. This mitigates your risk of interest rates rise because you'll only pay the higher rate on the variable portion of your home loan. However, if interest rates drop, you'll also only receive savings on the variable portion. There are usually no restrictions on making extra repayments on the variable portion of your loan, but break fees may apply to the fixed portion of your loan. It's best to check with your lender. The home loan that works for you will depend on the individual needs of your family and your financial circumstances - so it's worth comparing options.
3. Optional Extras
There are a few common options that crop-up on many borrowers' home loan journeys.
An offset account is a handy feature commonly found on variable-rate home loans, and to a lesser extent on fixed-rate home loans. They usually come with a monthly fee or a 0.10% premium is placed on the home loan rate, but they can be effective at reducing interest payable over the life of the loan. The money is your own, sequestered away from the rest of the home loan. If you have $50,000 in an offset account, and a $500,000 mortgage, you will only pay interest on $450,000. You usually also get access to a debit card, so an offset account can act like your everyday bank account. However, beware because not all lenders are 100% offset - some might only offer 80% offset for example.
A redraw account also lowers interest payable on the home loan, but is done through making extra mortgage repayments rather than acting as a bonafide separate bank account. The bonus with a redraw is they are usually included at no extra cost on many variable-rate home loans and customers can redraw money if they need it. A downside is that it's not sequestered away from the home loan like with an offset account. There have been instances of banks in the past that have taken money out of the redraw facility if their systems detected (correctly or incorrectly) that the customer was at-risk of falling behind on repayments. Many customers also use a redraw facility for rainy day funds. However, the risk with this is if you have say $50,000 remaining on your home loan, and $50,000 in the redraw, the lender could automatically siphon those funds into paying off the home loan.
Packaged Home Loan
Packaged home loans are usually a special subset of home loans that bundle other financial products like credit cards, insurance and more. Products either come at no extra cost or are heavily discounted. Packaged home loans usually come with extra fees, reflected in the higher comparison rate. Packaged home loans can be a convenient way to get a bunch of extra products, but you'll have to weigh up the cost of convenience and if you'll even use them. They can also be harder to part with if it comes time to refinance.