Home Buyer: Mortgages and home loans made simple

26 June 2015 / Published in News & Stories

Buying a house is such an exciting process but it can be a little daunting with all the things you need to know. To make things a little easier we’re launching the Home Buyer series to help you through the entire process. We’re going to cover everything from saving for a deposit through to moving into your new home (and everything before, between and after!). Whether you’re buying your first house or selling up and buying your next one we hope you’ll find this series useful. This month we’re starting at the beginning and getting back to basics – explaining what a mortgage is and how a home loan works.

Mortgages and home loans

It’s not widely known but there is actually a difference between a mortgage and a home loan. Simply put a mortgage is the security you give to a lender for providing you with your loan. It is not usually the loan agreement. In contrast, a ‘home loan’ is an amount of money you’ve borrowed from your lender with the expectation it will be paid back over time with interest. Home loans are usually used when buying or refinancing residential property. So while there is a difference in these terms it’s likely you’ll hear them used interchangeably – people will often say ‘mortgage’ when they’re actually referring to their home loan.

What does security mean?

Throughout the buying process the term ‘security’ may be used by your bank, valuer or lawyer. What they’re generally referring to is your property and how it secures the fulfilment of your home loan repayments. If you fail to meet the obligations of your home loan the lender can sell your property, usually as a last resort, to help repay your outstanding debt to them.

What is equity?

Equity is the term used to describe the value difference between what your property is worth and how much you still owe on it. Initially your equity will be the amount you personally contribute to the purchase of the property (e.g. your savings and KiwiSaver first home withdrawal). Then as the amount owed on your home loan reduces and/or the value of your property increases, your equity should increases. Here’s an example: Year 0: you buy a $400,000 property with an $80,000 deposit. Property value = $400,000. Home loan balance = $320,000. Equity = $80,000. Year 1: you repay $10,000 of your $320,000 home loan. Property value = $400,000. Home loan balance = $310,000. Equity = $90,000. Year 2: you repay $10,000 of your $310,000 home loan and your property increases in value to $420,000. New property value = $420,000. Home loan balance = $300,000. Equity = $120,000.

Principal and Interest explained

For an ordinary term loan, the ‘principal’ is the amount of money you’ve borrowed under a home loan and ‘interest’ is the price charged by the lender for the use of the money borrowed. When you make a principal and interest payment a portion of your payment will go towards reducing your loan balance and the remainder will cover your interest cost to date. The more principal you repay, the lower your loan balance and therefore, in theory, the lower the portion of interest you will pay.

Interest rates

Fixed rates

Fixed interest rates are where you lock in an interest rate that applies to the loan for a set period of time (on terms ranging from 6 months to 5 years). They provide you with certainty of what your payments will be and remain unchanged during the term of your chosen interest rate. In circumstances where you choose to change (break) your interest rate before the completion of your fixed rate term, or in some cases make additional repayments, there may be a fee referred to as ‘early repayment adjustment (ERA)’.

Variable rates

Variable (or floating) interest rates are where the interest rate can change, generally with market conditions. This means your interest rate can increase or decrease at any time. With a variable rate you have a minimum loan payment amount that can change if the interest rate changes. An added benefit of a variable rate is you can make extra payments without any ERA fees being incurred.

Loan types

The following are some of the common loan structures you may come across when taking out a home loan.

Term loan - table

Interest rate options: Fixed or Variable rate.
Payment options: Fortnightly or monthly payments.
Maximum term of loan: 30 years.

On a table loan your payments (of principal and interest) stay the same and are spread out evenly over the whole term of your loan, subject to interest rate changes. At the start of your loan you’ll pay mostly interest and a little principal, and then as time goes on you’ll pay less interest and more principal.

Term Loan - reducing

Interest rate options: Fixed or Variable rate.
Payment options: Fortnightly or monthly payments. 
Maximum term of loan: 30 years.

With a reducing loan your principal payments stay the same and over time your interest payments decrease – so your regular payments decrease over time. 

Revolving credit facility 

Interest rate: Variable rate only. 
Payments: Monthly interest payments. 
No loan term.

A revolving credit facility is like an overdraft on a transaction account with no set principal repayments. Interest is calculated and accrued daily on the outstanding balance and then charged monthly. You can make repayments at your own pace and redraw additional funds up to your credit limit at any time. The lender sets a maximum limit and you must keep your loan balance within this amount.

Revolving credit facility with a reducing limit  

Interest rate: Variable rate only.
Payments: Monthly interest payments. 
Reducing limit frequency: Fortnightly or monthly reductions. 
Maximum term of loan: 30 years.

This is similar to the revolving credit facility but the credit limit reduces. Just like the revolving credit facility, interest is calculated and accrued daily, and then charged monthly. You can make repayments at your own pace and redraw additional funds up to your reducing credit limit at any time. You can choose fortnightly or monthly credit limit reductions which are based on when you’d like your revolving credit facility paid off (the maximum term is 30 years).

A combination of loan types and interest rates

You have the option to choose just one loan type and one interest rate for simplicity – e.g. a table loan initially fixed on a one year interest rate. Or you can choose a combination of loan types and interest rates to help give your more flexibility – e.g. a table loan initially fixed on a two year interest rate, a table loan on a variable interest rate and a revolving credit facility.

The main thing to remember is that lenders are there to help you through the buying process and explain all your options – never be afraid to ask a question or request further information if you’d like to know more.

Check back next month for tips, techniques and alternative options to help you save for your deposit.


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