How Does A Mortgage Work?
It may sound simple, and most people will have a general idea but do they actually know the intricacies of a mortgage? Whether you knew or not, you are reading this article, so you are interested, so let us get the question answered.
I think the general understanding of a mortgage would be that the bank lends you the money to purchase a home. You will be paying that loan off for the next thirty-odd years or so, at the end of which the house becomes yours. Understanding some of the finer points of a mortgage may put you in a better position to choose a product that is going to suit your situation. Let us begin.
When you enter into a loan contract with a bank, the bank is agreeing to loan you a part of the money to purchase the home. One of the first things that they require from you, as they say, is your “hurt money” or “skin in the game” as lenders internally call it. What I am referring to is your deposit that you need to put down as your part of the mortgage. This portion of the home that you are paying for with your savings, initially, is called your equity. Let us use an example and imagine that you were buying a home for $500000.00 and had a $100000.00 down payment. Your loan would then be for the remaining $ 400000.00. Thus you would own $100000.00 of the home “being yours,” and the bank would have paid for the $400000.00. If you put this in a percentage the bank owns 80% of the property and you own 20%. If you take the size of the loan and compare it to the value of the property, you have a $400000.00 loan and a $500000.00 property. The Loan to Value ratio of this property is 80%. You will often hear when you are having conversations about a home loan, professionals talking about the LVR, this is the loan to value ratio. We know lenders are not giving out home loans because they are charitable organizations. They are there to make money and are very good at it. When you take out a home loan, you will pay interest on the loan. Generally, the interest rate of a mortgage is determined by the risk factor of the loan. There are several different factors, that will determine the risk factor. The main four that are initially looked at would be, Loan To Value Ratio, Type of Security, Purpose of Security, and lastly the way that the loan will be repaid. What is meant by the last point is the loan interest only or principal and interest.
The higher the risk factor of a loan, generally, the higher the interest rate that the bank will charge for that mortgage. So if the loan to value ratio is high, the riskier the lending for the bank, why, you ask? A client who has little to no “skin in the game” or “hurt money,” will probably be less stressed about losing their deposit than a client who put a sizeable one down who has been saving it for years. A client who cannot put a large deposit down may also not have as much disposable income in their household, and would maybe be at higher risk of default. The type of security( the property purchased), also plays a role. A family would work harder to make ends meet to keep the family home they are living in than to hold a second investment property. Hence the difference in investment and owner-occupied rates. Some lenders see small apartments as a high risk, and will not finance them, others will, but the interest rate is high. I think you get the picture. The more risk factors involved for the bank, the higher the interest rate.
Paying Off Your Mortgage
When it comes to a loan, there are two ways that you can pay them, either you can pay the principal and interest off, or you can pay interest only repayments. The interest on a loan is calculated daily and charged monthly. If you wanted to work out the daily interest on our $500000.00 loan at say 4%, you would go $500000.00 x4% and divide that by 365. That would give you the interest payable for that day. If you are paying interest only on a loan product, the interest portion that we calculated and added up for a month would be all you paid. The loan balance does not ever go down; it stays at $500000.00, so you are not paying the principal down. The bank thus maximizes its interest that it earns, and the client pays a much lower payment than they would a principle and interest repayment. Interest-only loans are generally used for investment property and out of a 30-year term, you would be able to have 5 of those years as an interest-only loan. When you get to the end of that, you can generally extend the interest-only loan for a further five years. The tricky part is when that is at an end you still have a $500000.00 loan to repay but now over 20 years, so your repayment is going to make a significant jump upwards. Again a bit more risk and investment interest-only loans have a higher interest rate to go with them.
The way that a “Principal and Intrest “rate mortgage works is that the monthly repayment that you pay will be divided up. Part of that repayment will go into the bank’s profit as the “interest” part of the loan, and the rest left over will pay down the principal part of the Home loan. For example, if you had a $400000.00 loan and your monthly repayment was $2000.00. Interest would be calculated daily on the mortgage, and let us say that it added up to $1800.00. At the end of that month, $1800 would go to the bank as interest, and the remaining $200 would pay down the $400000.00 loan. At the beginning of the next month, your principal loan amount left would be $399800.00. Intrest would now be calculated on this amount, so if next month has as many days in it your interest component will be less and you will pay off more of the principal. Now you can see why you pay more interest upfront at the beginning of the loan and this declines as the principal comes down towards the end of the loan. Anything you pay in extra on a variable home loan in a month will come off the principal of the loan, and you will be saving in interest. Hence if you can, it is always good to put as much free money into your loan as possible to save on interest. Another point to note. If you were to change your monthly repayments to weekly. You would pay a small portion of the principal off of the loan in the first week. This means that the interest calculation daily over the next week will have a lower amount, and the next week, even lower. Increasing your frequency of repayment has quite a substantial compounding effect over a 30-year loan term. Simply doing this can save you thousands of dollars over the life of a loan.
Another thing to understand with regards to a mortgage is the two main types of loans that you can get with regards to the interest rate. That being either a variable or a fixed rate mortgage. A variable home loan, is exactly what it says. Your interest rate will move with changes to market interest rates. The benefit of a variable interest rate is that you normally have the freedom to pay as much into the loan as you would like, without any penalty. This makes this type of loan very attractive to clients who are trying to pay their mortgage down quickly and save on interest charges. Many Variable loans also have redraw facilities attached to them or an offset account. To read about the offset and redraw facilities, click here
Another advantage of having a variable account is that A fixed loan, is one in which you choose the period, usually 1-10 years to fix the loan as well as the rate. The advantage of this loan is there are no surprises with regards to increases in repayment over the term, and it is great if you are budgeting. The disadvantage is that you will be penalized with interest fees if you refinance before the fixed period is up, or if you would like to pay off extra of the home loan within the fixed period. Many of these loans have an extra cap that you can pay over and above your minimum repayments, but they are usually quite low, so do restrict the client quite a bit, if that was there goal.
A question that often gets asked is what the “comparison rate” is? You will see that with most advertised rates, by law there should be a comparison rate advertised with it too. Many mortgages will have the interest rate that you will be paying over the life of the loan, let us say for argument’s sake it was 3.30%. Loans often come with various establishment fee’s as well as monthly account keeping fee’s. Or you get a loan with an introductory or honeymoon rate of 3.15% for the first two years and then after that it jumps up to 3.99% and again may have fees. A comparison rate bundles the costs associated with loan fee’s, as well as introductory loan rate, jumps into a single rate to show you what the loan is actually costing you. This enables you to compare it to other loans, hence the name. Comparison rates do give you a good idea of what a loan is costing you, but can sometimes vary in how they were calculated. A good idea would be to chat with a good mortgage broker Adelaide, or a lending representative at a lender to see how it was calculated.
What I have covered above should give you a much better understanding of a loan and how it works, hopefully. This information is meant to act as a general guide, though, and you should really talk to a professional to go through your options and make sure that you are finding a product that suits you. We would love to have a chat with you, especially if you are still wondering about something or have a few questions. Its a free chat so get in touch with us.