Home Loans: Learn the Lingo
Buying a home is super exciting. Some of this excitement, however, may be extinguished when it comes to deciding what sort of home loan you need. With only 40% of those we interviewed contributing to the home loan decision, we thought it was necessary to start with the fundamentals, the "lingo" before moving on.
There are many different 'types' of home loans. Combinations of owner occupied vs. investment; fixed vs variable interest rate loans and interest only vs. principal and interest. Let's unpack these differences below.
1. Owner Occupied vs. Investment Loans
This is the purpose of the property you need to home loan for. If you plan to have the property as your primary residence / live in your home, it is owner occupied home loan. If you are not and you are using it to for example earn an income or reduce your tax bill, it is an investment home loan.
2. Interest Only vs. Principal & Interest home loans
Home loans are made up of two components:
- Principal - the amount you need to borrow. For example, if you bought a $1.4m home (including upfront fees) and you have saved $400k, you only need to borrow $1.0m. This $1.0m amount is the “Principal”, the amount you are borrowing from the bank or lender to buy your home.
- Interest - the amount you pay to the bank or lender to borrow money from them. It is often expressed as a % (interest rate) which is applied & charged to the outstanding loan amount. It is the cost of borrowing money. This changes from time to time and is set by the bank / lender. Interest rates are often spoken about on the news and are one of the costs banks/lenders charge you to borrow money from them.
So with this in mind, Principal & Interest (or P&I) home loans are ones where the amount you pay covers both interest costs and some of the principal.
Interest only (or IO) home loan, you pay off the interest part of the loan - not the principal for certain period of time (e.g. 1-5 years at a time for owner occupied home loans). This type of loan may provide lower repayments during the interest only period, but costs will then increase afterwards. Moreover, during the interest only period, you never reduce your principal (i.e. amount you have borrowed).
3. Fixed vs. Variable Interest Rate
Fixed interest rate means the interest rate does not change over the specified duration. E.g. 4.0% fixed over two years means that your repayments will remain at 4.0% for two years. The benefit of this type of loan is that you will know exactly what you will need to pay each month for that duration of the loan.
Variable interest rates on the other hand will go up and down with bank/lender changes in interest rates.
You can choose to fix some of your loan and vary the rest. For example, if you require a $1m loan, you could choose to borrow $400k with a fixed interest rate and $600k with a variable interest rate. This does get a bit more complex, but may be suitable for you.
Which one is right for me?
With the Owner Occupied vs. Investment decision black and white (i.e. will you be living there or not?), the choice of which home loan you go with (P&I vs. IO and Fixed vs. Variable vs. combination) depends on your financial position & your risk appetite.
Now that the basic lingo of home loans is nailed, we can move onto more practical decisions, like "how much can I borrow?", "to rent, or to buy? that is the question" and other upcoming blog topics.
If you have other home buying questions you would like answered, please contact us here.