Buying a Home Smart Guide

3. Types of loans

What youll learn in this step: The pros and cons of fixed-rate versus variable loans.

Variable versus fixed

The two most common home loans are variable-rate and fixed-rate loans.

Variable-rate loans track movements in the official cash rate, which is set by the central bank, the Reserve Bank of Australia. If the official cash rate goes up, all things being equal so does the interest rate on your loan, along with your repayments. The flip side of the coin is that you save money if the RBA cuts rates. You can ride the swings and roundabouts of interest rate movements.

With fixed-rate loans, you choose a term usually one, three or five years over which the interest rate will remain the same, regardless. You might do that because you think interest rates are going to rise or because you need some certainty about your repayments perhaps because youre borrowing to the maximum. However, if you lock into a fixed mortgage and rates fall, you'll miss out on the lower rate.

Traditionally, fixed-rate loans don't offer the same flexibility or features as variable ones. Many variable loans offer redraw facilities, for instance. A redraw facility allows you to make additional repayments on your mortgage, with access to the funds if you need the money back later.

Its a useful facility, but bear in mind that its usually only available on standard variable-rate loans, which are about 1 percentage point more expensive than basic variable loans. And there may be a minimum amount you have to redraw and a fee.

A way to take advantage of the features offered by the two types of home loan is to split your mortgage, putting half on a fixed rate and half on variable-rate terms. Check your lender doesn't charge you twice for a split mortgage though you dont want to pay two sets of establishment fees and two sets of ongoing fees.

Be aware, too, that therell be a difference between the rate on a fixed loan and that on a variable loan the security of a fixed rate often comes at the cost of a higher rate.

Honeymoon rates

Many lenders offer honeymoon rates. The rates on these loans can be significantly lower than the prevailing variable interest rate. But they last only a limited time usually six to 12 months then the loan reverts to the standard variable rate.

Its a dud deal if the short-term gain of the honeymoon rate is outweighed by higher interest costs over the full term of the loan. Do your sums and make your repayments in those early months at the level theyd be if the standard interest rate applied.

Professional packages

Lenders dont necessarily advertise the fact, but many offer what are sometimes dubbed professional packages to borrowers in certain jobs, those above certain income levels, and good clients who have most of their accounts with bank.

You can probably shave half a percentage point off the interest rate but if you dont ask, you dont get.

Line of credit loans

The idea behind line of credit loans, also known as revolving credit loans, is that you pay your salary directly into your mortgage account so it goes to work straight away, reducing the principal owed and thus the interest charged on the loan.

Of course, over the next week, or fortnight, or month youll have to draw on some of that money, but itll be at work in the meantime and with any luck you might leave more than the required repayment behind, making a permanent dent in the principal.

Thats fine, but these loans often attract a higher interest rate in the first place, and the danger is that if youre not disciplined about withdrawals youll actually make your mortgage bigger rather than smaller.

If youre organised and disciplined, you could set up a do-it-yourself line of credit using a regular home loan and your credit card.

Youll already have a monthly or fortnightly repayment scheduled, but each pay day transfer the rest of your money barring a bit of cash to your home loan account. Now use your credit card for any spending during the month: groceries, petrol, entertainment, bills ...

When the credit card debt falls due, withdraw the required amount from your home loan account and pay your card off in full, to avoid any charges. Just make sure you dont spend more on your card than you put on your home loan in the first place.

Bridging finance

Bridging finance is an expensive answer to the dilemma of buying one home without having yet sold the other. Without a sale, you probably wont have the readies for the deposit on the new place and thats where bridging finance comes in.

Depending on your financial circumstances, your lender may be reluctant to provide it, and it will be costly.

The best idea is not buy before youve sold. You can never be sure youll sell your existing property in good time, or that youll achieve the price you expect and if you dont, there could be a big hole in your sums.

Deposit guarantee bonds

One option when all your capital is tied up in your existing home is a deposit guarantee bond. The bond issuer will charge you about 1 per cent of the size of the deposit otherwise required on the house $600 for a $60,000 deposit on a $600,000 house, say to guarantee to the seller that theyll get their money when the contract is finally settled (rather than the deposit upfront, now).

Parting with several hundred dollars, instead of many thousands, can seem attractive but if you fail to come up with the money when the time comes to settle, the bond issuer will pay the vendor and then knock on your door. And deposit bonds are sometimes secured against your existing family home.

Home equity loans

The more you pay off your home loan, the more of the property you own the more 'equity' in the property you build up. These days its possible to borrow against this equity for further investment perhaps another property, or shares.

The advantage of borrowing against this equity rather than taking out a personal, investment or business loan is that the interest rate will be much lower. But remember that youre putting your home up as security for this loan.

Read more about:

Banks milking home renovations boom, Angela Cuming, January 8 2006 - The Sun Herald: Major lenders are offering loans for home renovations as more people turn to home improvements rather than buying property.