Mortgage Finance Guide

These are often sold by lenders as “Standard Variable” or “Basic/Base Variable” loans. They are variable because the interest rate is exactly that - it can change. Typically, the rate moves in the same direction as the Reserve Bank cash rate, but out of cycle movements are possible especially if lender funding costs change.

Variable Rate Loans are popular as there are generally few or no restrictions. Most variable loans are flexible, allowing unlimited extra repayments & redraw (on funds paid in advance). Some lenders allow you to have these products with an offset account (or multi offset).

You can split your loans if required, and this is common where you have loans for different purposes.

This is historically a less sought-after product, but Fixed Rate Loans are currently pricing well below variable rates. However, they require a more detailed understanding from the borrower.

The interest rate is fixed usually for a term of 1 to 5 years.

Fixed rates can be restrictive, most lenders do not offer 100% offset on fixed (with some exceptions). Redraw is usually not available or very limited, and extra repayments can trigger “break costs”.

Break costs occur when you prepay more than what is allowed under the product. The bigger the prepaid amount and the longer the fixed period, the more that break cost may be. If interest rates continue to decrease after fixing, your break cost liability will increase.

Be aware that the rate quoted is generally not guaranteed, with many lenders applying the fixed rate applicable at settlement. For a fee, Rate Lock exists to “hold” the rate for a period (up to 90 days typically).

You can have multiple fixed splits, including different portions of debt fixed for different periods of time, or to help increase the amount you can prepay (e.g. the lender may allow $10,000 of extra repayment under one fixed loan, but 4 smaller loans of the same fixed term allow 4 x $10,000 = $40,000 in total extra repayments).

As the name suggests, you can have some of your loan fixed and some variable over two or more loan splits. You may be able to have multiple fixed splits too (e.g. for different fixed terms or to bypass extra repayment caps).

Principal and Interest or “P&I” repayments are designed to ensure after a specified term (usually 30 years) the balance of the loan is fully repaid, so each repayment is paying interest and principal. Initially, the P&I repayment is mostly paying interest, but as the loan term progresses and principal reduces, the interest component will reduce also.

The P&I repayment is a contracted ongoing repayment, based on the outstanding loan limit (not balance), the interest rate and term remaining. So the repayment will change over time as interest rates move.

Repayments can be weekly, fortnightly, or monthly. Weekly & fortnightly repayments are perceived as better, but this is not always correct. Weekly & Fortnightly are based on monthly repayments divided by four (4) and two (2) respectively. However, you end up making an extra month's repayment each year.

Interest Only or “IO” repayments do not require the repayment of principal for a period (usually a maximum term of 5 or 10 years). These loans usually come at a higher interest rate.

Generally, the overarching maximum term is 30 years for a home loan, so upon the IO term maturing, the P&I term will be based on the total period, less the IO period. Borrowers will usually find themselves with higher residual repayments. (If your loan term was 30 years with 5 years interest only, the residual term is 25 years P&I).

IO may suit some investors where debt is tax deductible, but it does not always mean an investor shouldn’t consider Principal & Interest from the outset. This will ultimately come down to the opportunity cost of the “saving” and borrowers should be aware of this.

Repayments for Interest Only loans are always made monthly.

Allows investors to prepare interest for 12 months. This may reduce taxable income in the immediate tax year.

Typically these are completed in June before the end of the tax year.

Interest capitalisation is when no repayment is required, instead the bank adds interest charges to the loan balance over time.

This option usually exists only for Line of Credit products, Bridging Loans or Reverse mortgages. Whilst the latter two products are dictated by circumstances, Line of credits are still available as a choice to borrowers with a genuine purpose.

In the 1990’s these products became synonymous with consumption - not always the best way to use your home equity! Effectively, they are an overdraft that offer greater flexibility, generally on an evergreen/revolving term (no stated fixed term).

Ideally, they were popular for investors who wanted interest to capitalise; however, when provided for personal purposes it meant that debt was being retired, and macro regulations were put in place to discourage their sale.

A redraw facility gives you access to funds you have prepaid in advance of the minimum scheduled repayments (or scheduled amortisation). You prepay debt either from lump sum repayment or by making regular extra repayments over time or both. These prepayments become available redraw.

Typically, redraw should be unlimited and fee free but some products may have costs to redraw or restrictions. Redraw is usually limited or unavailable for fixed rate mortgages.

Most lenders will advise what your available redraw is online. Your available redraw and your loan balance will form your loan limit.

It is important to view redrawing money as effectively “reborrowing” repaid money. Every time you use redraw your prolonging the life of the loan.

Often a misunderstood feature, mortgage offset accounts were first offered to manage tax, but extended to other mortgage products that were “packaged” with an offset capability. Today most basic/base variable products (without offset) now offer similar or lower interest rates.

Offset accounts offer the ability to isolate your savings from your loan, but whether it really works for you depends on your circumstances.

An offset account is linked to a loan, and the credit provider calculates the daily interest on the net balance (the loan balance less the offset balance). Sometimes offset accounts can add to the product cost so consider their real value.

For investors, should an amount you have previously repaid be “redrawn” you are effectively reborrowing it. From a tax perspective,  the ATO Purpose Test may apply to whether funds are deductible. An offset account set up at the outset can avoid this.

Also rather than pay you interest on your savings; it is effectively deducting it off the loan interest - as you don’t earn interest you don’t pay tax on it.

An offset account may therefore work well for people building a property portfolio. Do you need an offset account? You should seek tax / financial advice if you are unsure.

The ATO has published a tax ruling on the topic of redraw and reborrowing of funds

1. The ATO states “ Where a loan facility allows for redraws of extra repayments, we consider those redraws constitute new borrowings of funds that cannot be traced to the extra repayments. In this regard the term 'redraw' is a misnomer. It is in effect a new borrowing of funds.”.

2. The ATO States “We consider a draw-down from a line of credit account or sub-account, or a redraw from a loan account, is a separate borrowing. Therefore, the deductibility of the interest on that separate borrowing ends on whether the interest is incurred in gaining or producing assessable income or is necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income.

The Big Four refers to CBA*, Westpac*, NAB & ANZ. These are Australia’s big banks, and all listed on the stock exchange. Typically the big four banks have majority market share (over 75%) of the Australian mortgage market.

The Major Banks offer the biggest branch & ATM networks, and being deposit taking institutions their loans are largely funded by their customers through bank deposits (they also source funding through other markets). A strong deposit base can mean more control over the cost of funds, and subsequently a perception to withstand challenging economic circumstances.

Major banks are less transparent in their interest rates, with most standard variable pricing negotiated at a point in time. We call this “Pricing”. In recent times, they are more willing to price their fixed rates with the market.

Second tier lenders are authorised Australian Deposit Taking Institutions and are now regulated by APRA & governing bodies. Examples include Macquarie, ING, Bankwest, Bendigo & Adelaide Bank. Building societies & credit unions fall into this category. They may or may not have a branch presence, and often draw on ATM networks of other banks.

Second tier lenders will attract deposits by offering deposits, so like major banks may have less reliance on wholesale funding markets. They provide both competition and at times credit policy differentiation.

This category of lender won’t have a banking license so can’t accept deposits. They will source funds from wholesale markets through securitised funds or warehouse facilities (effectively investors with an appetite in backing mortgages).

Potentially, they may be more sensitive to borrowing costs triggered from local or global economic conditions. More aggressive credit policies may also carry more portfolio risk (for example Low Doc loans) which could be deemed riskier by investors.

A prime example is the GFC in 2008. When funding costs increased substantially, these lenders struggled to obtain funding as they carried loans less attractive to investors. Borrowers were impacted with rate rises even though the Reserve Bank was cutting interest rates. Despite these limitations, this segment can help drive competition and provide solutions to borrowers.

An option where financial circumstances are complex or difficult to source funding from traditional channels. There are many providers and getting an approval does not always mean the private lender has a funder.

It is important to use reputable private funders with quality investors backing the loans they approve. So price is less relevant in this segment, reputation is most important. If you need Private Funding, this is one area where you should consider obtaining assistance from a finance professional.

Getting a Mortgage(s) is not an exact science. In the most primitive sense, money is a commodity and in that regard the product offerings between credit providers have become increasingly homogenous.

Reputable finance brokers will always strive for good customer outcomes and will be cognisant of key laws (such as Conflicted Remuneration, Best Interest Duty) that provide the necessary regulatory framework to support and protect borrowers.

The interest rate at the start of your loan is important of course.

However, in our experience, the structure and subsequent conduct of borrowings is normally more material than the credit provider selected and the subsequent interest rates.

Therefore, give thought to having a plan on how you structure and conduct your mortgage(s) in the longer term too.

It is our preference, and supported by legislation, that you consider multiple options. Not just between different credit providers, but (and often more importantly) between different loan structures.

Legislation means we must also challenge your own preferences at times, where we think that these choices may not be in your best interests.

It is not possible or responsible for a broker to have access to every credit provider; however, we are not required by our Broker Group or others to recommend any particular credit provider. We do not have or impose any quotas or obligations in relation to making recommendations.

The likely interest rates available depend on the type of loan you seek (i.e. fixed or variable interest rate) as outlined previously.

More materially, interest rates are also driven by:

The basis of Repayments (Interest Only - "IO" or Principal & Interest - "P&I").
The Loan to Value Ratio ("LVR") - see Mortgage Acronyms.
The Purpose of the Loan (Investment or Owner Occupied).

We have included an indicative chart below for these:

The above is a relatively fluid process and can change over time. Interest rate settings are not just dictated by the credit providers, but the regulators too, whose macro policy settings can dictate the supply of different loan types.

Lastly, mortgage credit providers either offer a set or "carded" interest rate, or your broker may talk about "pricing" a loan. This is where an ongoing  discount is offered off a benchmark or standard interest rate.