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.
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 (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.
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.