Different types of home loans explained

SELECTING the right home loan can be just as important as choosing the right property.

But which loan is right for you? Here’s a quick guide to the basic types of loans you’re likely to come across.

Variable rate loan

Considered the most common type of home loan, a variable loan does what it says on the box – your rate varies based on interest rate fluctuations.

This means that if interest rates go down, your rate and subsequently your repayments will drop, too.

Conversely, however, if rates go up you’ll be paying more each month.

Australian Real Estate Home Loans director Andrew White says variable loans also offer other incentives.

"They certainly offer flexibility, with the ability to repay in advance of the minimum payments, which reduces the term of the loan and builds equity in the property," he says.

Fixed rate loan

At the other end of the spectrum are fixed rate loans, which allow the interest rate to be set for a certain period of time.

Most fixed rate borrowers will only fix their rate for the first few years of their loan, to avoid paying the higher rate for extended periods if interest rates suddenly drop.

White says the challenge is trying to pick when the rates are unlikely to fall any further, to lock in the lowest possible rate.

"If you go back some years, people were locking in at 8 per cent.”

They’re not rapt at the moment, because there’s penalties to get out of it," he says.

But for some people they’re the perfect option, as they offer can offer stability.

"There’s a single mum with two kids at the moment we’re dealing with who’s just gone through a divorce, and she’s locking in at 4 per cent for three years to get herself back on track.

"So it’s perfect for her, she doesn’t care if it goes down a bit, she wants to know what her repayments are for the next three years," White says.

Split rate loan

Not everyone who locks in a fixed interest rate wants to fix their entire loan amount, as they fear being stuck paying more than they need to if interest rates fall.

Instead, many borrowers will fix a portion of their loan amount, to lessen their risk and keep their future repayment options open. The rest of their loan will remain on a variable interest rate.

"Your split can be 50-50, 60-40, or you can make up a number.

"It gives you the ability to do both – put extra (repayments) on the variable portion, while having the stability of knowing what the fixed rate is going to be. If someone borrows a big amount, say an $800,000 loan, they might go $600,000 fixed, $200,000 variable," White says.

Interest-only loan

Traditionally used for investments, interest-only loans allow the borrower to pay off only the interest they owe on the loan, without paying off the loan itself.

Some of the thinking behind interest-only loans is that investors can pay the minimum off their loan while waiting for the property to increase in value, and can then sell it to cover the original loan amount and bank a profit.

But White says the regulatory body – the Australian Prudential Regulation Authority – is cracking down on interest-only loans.

"Traditionally an interest-only loan is for investment purposes for an investment property, because it maximises the negative gearing allowances, but the banks are being asked to look more closely at them now."

"In simple terms, I think they’re worried about people never paying off their mortgage. The risk there is considered a lot higher at the moment," he says.

— realestate.com.au