Nayade .

Below are some observations as reflected from the data obtained from the RBA for the 12-month period ending 31 August 2020. Whilst both the absolute numbers and the relationship between rates will change, these observations provide you with useful information when you are shopping for a home loan by explaining some of the macro risk profiles considered by lenders.

1. Principal and Interest (P&I) interest rates are generally lower than Interest Only (IO) interest rates. Based upon a quick look at two major lenders (Macquarie and Westpac), P&I rates are lower than IO rates by 0.7% pa and a whopping 2.25% pa respectively!!!

This spread in rates can change if lenders form a different view of future economic conditions including inflation. Right now, lenders are rewarding borrowers who can demonstrate a capacity to gradually repay their loan. (PS the sting in the tail for IO loans is that whilst the repayments might be lower (in dollar terms) than a P&I loan, the debt servicing rate for IO loans is higher than for P&I loans; the logic being that after the IO period ends, the loan principal needs to be repaid over a shorter period of time so the monthly repayments of the principal are higher).

2. Rates for Owner Occupiers (OO) are sometimes lower than the rates for Investors (IN). Currently, the Variable Rates for an Owner Occupier are about 0.3% pa lower than for a similar Variable Rate product for an Investor.

3. The relationship between variable rates and fixed rates is more complex. Depending upon lenders’ views of future interest rates (and a whole bunch of other economic factors), the Variable Rates can be higher or lower than the Fixed Rates. Currently, Variable Rates are lower than most similar Fixed Rate products. And, the difference in interest rates between the two increases as the Fixed Rate term increases (the lowest Fixed Rate term is 1 year and the highest Fixed Rate term is 5 years).

4. The Loan to Value Ratio (LVR) also impacts the interest rate you will pay. If you have an LVR of over 80%, you can expect to pay a premium of anywhere up to 0.5% pa (and perhaps higher). It is also worth noting that loans with a high LVR (mostly over 80% but sometimes a bit higher if, for example, you are an eligible borrower (e.g. medical practitioner)), also require borrowers to pay Lenders Mortgage Insurance (LMI). LMI is an insurance policy the borrower pays to protect the lender in the event of a default and is often capitalised on top of the loan amount. (Note: LMI also has some hidden costs to the borrower in the event of default but more on that elsewhere).

5. The size of the commitment suggests that lenders slightly favour loans under $1.0M over loans. However, the differential is not significant. – between nil and 0.1% pa.

[1] RBA Data: https://www.rba.gov.au/statistics/tables/#interest-rates

The marketplace for home loans

– The lending marketplace for consumers is large and confusing – particularly in the home loan and more broadly, the residential lending space (home loans and investment property loans).

– Apart from the big 4 retail banks (CBA, Westpac, NAB and ANZ), there are regional banks which operate in each State, credit unions and mutual lenders (which are ‘owned’ by consumers) plus the growing range of online ‘fintech’ lenders who only offer consumers loans via their website.

Brokers have access to many of these lenders plus even more as they can obtain loans from lenders who only lend money to consumers via a broker distribution channel.

– Research by KPMG[1] in 2019 indicates that the big 4 banks have a share of over 81% of the residential property mortgage market. And, as over 55% of borrowers use a broker[2], brokers also place a lot of their clients’ loans with the major lenders.

So, whether you use a broker or whether you walk down to your local high street bank, the big 4 dominate the lending landscape. Most borrowers probably feel that if they have a choice of 4 (or 5 or 6 if you include regional banks which are available in most States) of largest lenders, they would be getting an ‘ok’ deal – and that the options they are being offered by the big 4 represent what is available across the lending industry.

And for many borrowers, this might well be true – but it is not necessarily true.

The reason this approach of walking down your local high street is appealing to many borrowers who have not used a broker is because research has shown we don’t like too much choice. We do like choice, but not too much. And more than 4 or 5 to choose from quickly becomes ‘too much choice’.

So, with over 40 lenders which most brokers deal with, the choice is far too large to consider for most borrowers.

That is one of the main reasons why borrowers use a broker – to sort through the ‘too much choice’ factor quickly and efficiently so the borrower can approach a lender whose product is suitable for the borrower.

How do we shop for home loans?

The KPMG research shows a number of interesting facets in obtaining a loan:

– We prefer to research online (87% use and prefer the internet) but when it comes to the application, we are more likely to opt for face to face (56%) – but then, we prefer to revert to online service (80%). And, we really don’t like call centres and we try to avoid them whenever possible!!!

– 44% of those who have previously taken out a loan preferred to apply via a broker Vs 41% using their existing financier and 15% preferring to use a new financial institution.

– And of those who use a broker, 67% renegotiate their interest rates at least once every 5 years compared to 53% for those who applied directly to a lender. At BIR Solutions we do this every year with your existing lender and every 2 years with other lenders.

– The older we are, the more likely we are to use our existing lender.

– Roughly two thirds of respondents have 2 or more financiers.

– Reasons we choose brokers or new financial institutions – or decide to stay with our existing financier:

> Interest rate or price related data: 51% of those borrowers who used a broker channel and 59% of those who went to a new financial institution, did so for interest rate related reasons.

– and this was regarded as a significantly important reason. Only 19% of those who used their existing financier prioritized interest rate related reasons and they did not rank this reason as being an important reason for choosing their existing financier.

> Convenience: 35% of those borrowers who used a broker related channel and 65% of those who used their existing financier did so for convenience related reasons.

> Trust: was the third main area identified as reasons borrowers chose brokers (14%) or new financial institutions (27%) or they decided to stay with their existing financier (16%).

Based upon my exposure to borrowers, lenders and the broker channel, this research makes intuitive sense.

[1] Savings.com.au: Big banks lose market share in tough home loan environment by William Jolly

[2] The Adviser: Broker market share bounces back by Charbel Kadib

[3] Ibid To Sell is Human, Dan Pink p. 234

[4] Ibid, KPMG

[5] Subject to your consent – of course!

Before we start….

For further content, please visit https://www.bir.net.au/blog/

And, if you would like a Free Property Report, you can order yours here: https://www.bir.net.au/report-request. You can obtain a report for a particular property, suburb or region in Australia, so you can make informed property decisions. Plus, our suburb reports now provide a comparison report of up to 5 suburbs you want to research.

Any questions, please ring me, Michael Royal 0411 190 474 or email me: michael.royal@bir.net.au. And you can also book a meeting with me: https://calendly.com/michael-royal/chat-re-finance

Now, back to the Article! 😉

At its simplest level, there are 2 types of interest rate products available for the housing loan market in Australia – Variable Interest Rate products Vs Fixed Interest Rate products.

But this is just the start! Many lenders, for example, offer Fixed Rate products with different terms ranging from 1 year all the way through to 5 years.

And, there are 2 ways you can pay back the amount you borrow – gradually over time (referred to as Principal and Interest repayments) or in a lump sum (referred to as Interest Only repayments). Within the home loan lending environment, Interest Only products don’t tend to get repaid but rather, they revert to a Principal & Interest product after the Interest Only term expires. Interest Only terms are typically somewhere between 1 to 5 years while the remaining Principal & Interest term might be a further 25+ years on a 30-year term loan.

And if you take out a 30 year loan with a 5 year Interest Only option, your Principal repayments for the remaining 25 years and which kick in after the expiry of your 5 year interest only period will be proportionately higher than if you started off repaying your Principal at the commencement of your 30 year loan.

Plus, there are some lenders who offer a Variable Rate Line of Credit and there are some who allow you to prepay your interest a year in advance (which can be handy when you have a higher taxable income in a year which you can offset with the prepayment of interest when the interest is tax deductible).

All home loan products essentially take into account a mix of these 4 options. Each option combination has a different risk profile for the lender and is likely to have a different interest rate (or price) being charged to the borrower. There are no ‘set rules’ or even ‘rule of thumbs’ you can use to assess the perceived risk as risk profiles can change over time and lenders are continually updating their risk profiles. Below are some current risk profiles as identified in recent RBA data (as at October 2020).

There are a number of additional reasons the interest rate charged by a lender might vary in addition to the mix of products selected by the borrower – plus some of these factors might even result in particular lenders saying ‘no’ to providing finance:

– The borrower’s profile (including income, expenses, assets, liabilities, credit history, profession).

– The purpose for borrowing (typically either home (owner occupier (OO) Vs investment (IN); or established Vs off the plan Vs land & construction).

– The borrower’s identity (a natural person (like you and me!), company, trust, partnership or super fund).

– The amount being required to be borrowed (the total amount as well as the amount compared to the borrower’s income).

– The loan to value ratio (LVR) and whether the LVR is above the lender’s LVR limit resulting in the lender requiring the borrower to pay lenders mortgage insurance (LMI).

And finally, here are some other things to be aware of:

– Additional features provided by a lender may result in a higher interest rate as compensation for the lender for providing these features. For example, a loan without an interest offset account and redraw facility may have a cheaper interest rate. Additional features like an offset account can be very useful as they can reduce your total interest cost – and they may even be useful to have ‘in reserve’ in case you do need them – but as with all things, make sure you have thought this through otherwise you might be paying for something you never were likely to use.

– Interest rates vary between lenders as well as between a lender’s products. So, it is wise to do your homework and review the market. Nevertheless, not all lenders are going to be on ‘Page 1 of Google’. That is why it is prudent to consider using a great broker. Great brokers know far more lenders and lending options than could ever fit on Google’s page 1.

– No matter how attractive a lender’s interest rates appear in the marketing and advertising blurb, not all lenders’ products are available for all borrowers. As noted above, some lenders have quite tight restrictions on the criteria they use when considering whether to offer an applicant funding – and so you might not qualify for their ‘low rate’ product. Unwary borrowers can waste a lot of time preparing loan applications for loans they were never going to get or at a rate they were not going to be offered because they were not made aware of all the lender’s restrictions. Again, this is why applicants should consider using a great broker – because great brokers know more about each lender’s products than consumers and they know who and what to ask if there is a potential issue with a particular assessment criteria used by a particular lender.

– Beware ‘limited time’ offers with low interest rates – or honeymoon rates as they are often called. These rates expire and at the end of that time, your loan will revert to the lender’s then current interest rate.

– Fees and charges can vary for each loan. When considering fees and charges, Choice 1 suggests you need to take these into account under the heading ‘Watch the fees.’ Choice lists the following fees for consideration (I have regrouped them so it is easier to read:

– Upfront charges: LMI

– Ongoing fees: monthly or annual fees.

– Discharge fees & Break costs

I agree. However, be careful of not over-estimating the impact of fees and charges. For example, on a $500K loan, an interest rate differential of 0.1% pa equates to $500 pa. At present, most annual fees charged by lenders are less than $500 pa – so an interest differential saving of 0.1% pa when paying an annual fee of (say), $400 pa would mean you are ‘ahead’ by $100 pa. And even then, when we are looking at the overall cost of interest, this is not a great deal and in many cases, would not be considered material to your decision.

[1] Choice: https://www.choice.com.au/money/credit-cards-and-loans/home-loans/buying-guides/how-to-choose-the-right-home-loan

Before we start….

For further content, please visit https://www.bir.net.au/blog/

Now, back to the Article! 😉

Introduction

Commonwealth legislation requires that for every home, car or personal loan advertised, a comparison rate has to be quoted. But lenders also have to include a warning about the accuracy of the comparison rate.

Comparison rates were originally introduced as part of the Uniform Consumer Credit Code in 1994. The UCCC has since been replaced by the National Credit Protection Act (NCCP) which includes the National Credit Code (NCC) as Schedule 1 to the NCCP. Comparison rates are set out in Part 10 of the NCC. Compliance with the provisions of the NCCP are governed by ASIC (Australian Securities and Investment Commission).

As ASIC says on its own website, ‘The comparison rate includes: the interest rate and most fees and charges’. It goes on to say, ‘A comparison rate does not include all fees and charges. For example, the comparison rate does not include: government fees and charges (such as stamp duty and mortgage registration fees) and charges that are only charged in certain circumstances (such as early repayment fees and redraw fees), for example if you pay off the loan early.’ And in wrapping this explanation up, ASIC says, ‘The comparison rate only allows comparison based on cost, and will not include other factors that may make a loan more attractive, such as access to fee free accounts or flexible repayments arrangements.’

CBA also goes on to say a comparison rate does not include ‘cost savings such as fee waivers or the availability of interest offset arrangements which can influence the cost of a loan.’ And Finder.com.au adds in late payment fees, deferred establishment fees and conveyancing fees.

After reading this, it’s fair to ask:, ‘Is a comparison rate useful?’ That depends on what you want to achieve and how relevant the data is on which the comparison rate is based.

Features of the Required Comparison Rate

– The Government’s comparison rate is based upon a loan amount of $150,000 and a loan term of 25 years.

– The comparison rate takes into account:

> The interest rate includes any ‘revert to’ rate which applies to the loan after a set period.

> Fees and charges including upfront costs like establishment fees and valuation fees, and ongoing costs such as monthly or annual fees.

> Repayment frequency.

– You can calculate your own comparison rate but to do so, you will need the following information and preferably, a comparison rate calculator:

> Loan amount

> Loan term

> Repayment frequency

> Interest rate

> Monthly account fee (if any)

> Annual fee (if any)

> Establishment fee (if any)

> Valuation fee (if any)

> Mortgage documentation fee (if any)

> Settlement fee

Pros of the comparison rate

– It ensures lenders cannot completely hide all ‘hidden fees and charges’. In this sense, it is a good guide for borrowers.

– Because comparison rates take into account fees and charges as set out above, the rate of interest tends to be higher than the quoted interest rate which excludes fees and charges.

Cons of the comparison rate

– It does not reflect the actual comparison rate for your loan – unless of course your loan is for $150K over 25 years.

– It does not reflect the impact on the quoted interest rate provided by most lenders for most home loans as most home loans are well above $150K (the average Australia-wide was approximately $450K in December 2019.)

– As most fees and charges are fixed in nature, at the loan value of $150K, the impact on the interest rate would be significantly higher compared to, say, a $750K loan. On a straight comparative basis, the impact on the interest rate for the $750K loan would be one fifth of that calculated on the $150K comparative rate loan.

– If your home loan is not for 25 years, the comparison may become less relevant.

Our take

– Comparison rates are useful indicators but should not be used in isolation for all the reasons identified above.

– Do your own research before you proceed to ensure you understand all the costs a lender will charge you.

– Use a broker to do the hard work for you! Brokers have software which can show you the total cost of a loan over the life of the loan and also over shorter periods (eg the first five years of a loan). This can be very useful as you might be contemplating refinancing or moving well before your loan term expires.

[1] ASIC

[2] Commonwealth Bank of Australia (CBA)

[3] CBA – ibid

[4] CBA – ibid

[5] Finder.com.au

[6] Canstar quoting from data prepared by the Australian Bureau of Statistics (ABS) which was analysed by Commsec

Introduction

When you apply for a loan, you will often have to choose between Principal & Interest (Principal & Interest) payments and Interest Only repayments. As the name suggests, with Principal & Interest payments, you are paying your lender the interest cost for the month plus a portion of the principal you have borrowed. Over time, your loan balance will reduce. With Interest Only payments, you are only paying your lender the interest cost for the month so your loan balance will not reduce.

The type of payment you choose (between Principal & Interest and Interest Only) is likely to impact the interest rate you are charged. In the data below, sourced from the RBA’s most recent set of statistical tables (current as at October 2020), you can see that there is a 0.7% pa premium to have an Interest Only facility compared to a Principal & Interest facility.

Further, depending upon a lender’s perception of the current market risk as well as your personal risk, they might not be willing to offer you an Interest Only option, preferring you to take up a Principal & Interest facility.

Lenders typically favour Principal & Interest as it reduces your loan and therefore their exposure over time. It also fits in nicely with their expected end goal: that your loan is repaid. Whilst you can repay your loan by selling your property or refinancing with another lender, repayment of the loan in a steady repayment stream over the life of the loan is often seen as preferable by lenders.

Principal and Interest Payments

Features

– The monthly repayment is based on the current interest rate, the loan term and the balance required at the end of the loan term. For a Variable Rate loan over a typical 25 loan term, the balance at the end of the loan term is normally set at nil. If, however, you had an Interest Only facility for the first three years of your loan, the Principal & Interest monthly payment amount for the remainder of your 25-year loan would be higher than if you opted for a Principal & Interest facility from Day 1 as there will be three years fewer in which to repay the principal amount.

– As can be seen below, the amount of the Principal & Interest repayment devoted to repayment of the principal increases over time as the interest is calculated on the principal balance remaining at the end of each month.

Note: This analysis excludes fees and charges.

– The higher the interest rate at the time you take out the loan, the higher the overall repayment and the greater the proportion of the repayment which will be devoted to paying the interest (and proportionally less will be devoted to the repayment of the principal).

Note: This analysis excludes fees and charges.

Pros of Principal & Interest Payments

– As noted from the RBA data, you may receive a lower interest rate so more of your repayment can be allocated to a reduction in principal. For example, over a year, for a $500,000 loan, if the Principal & Interest rate is 0.5% pa interest rate lower than the Interest Only interest rate, then this difference can be used to repay a further $2,500 in principal.

– Because Principal & Interest payments are considered more prudent by lenders, a loan with a Principal & Interest facility is often easier to obtain.

– Every time you make a reduction in the principal owing, there is a compound effect on the amount of future interest you have to pay as with Principal & Interest, the interest you pay is based on the balance of the loan outstanding at the beginning of the month. (This is why making additional or slightly higher payments each month is recommended as the benefit of the principal reduction has a compounding effect for the balance of the loan period).

– There is an inherent reduction in stress levels when you are reducing the principal owing – sometimes the satisfaction of seeing the balance reducing can give you a nice internal smile at the end of a day!

Cons of Principal & Interest Payments

– Your cash payment is higher each month as you are paying your interest plus a portion of the principal you borrowed.

– For Investors, part of your cash flow is tied up on non-tax deductible repayments (i.e. the repayment of the principal). Please seek independent tax advice before considering this issue.

Interest Only Payments

Features

– Each month, you only pay the lender the interest you owe.

– At the end of the month, the same amount is owing to the lender as was owing at the start of the month – and this does not change during the term of the Interest Only loan.

Pros of Interest Only Payments

– You do not need as much cash flow available each month to make the monthly payments.

– There may be tax deductible benefits for Investors. For this, please seek independent tax advice.

Cons of Interest Only Payments

– As noted in the RBA data, your interest rate may be higher than if you had selected a Principal & Interest product.

– It can be harder to obtain than a Principal & Interest product as many lenders have a natural bias in favour of Principal & Interest products.

– Your loan balance does not reduce.

– In times of tough economic conditions, if housing prices suffer a fall in value, you may find it harder to obtain refinance as your loan to value ratio (LVR) may have increased more than if you were paying Principal & Interest payments.

– When it comes time to revert to a Principal & Interest repayment, your payments will be higher than you would have paid at the beginning of your loan. Based on the above examples, at an interest rate of 3.0% pa, on a $750,000 loan over 25 years, the Principal & Interest payment is $3,556 per month. If you had a 5-year Interest Only product and then reverted to Principal & Interest at the end of the 5-year period, your Principal & Interest payment for the remaining 20 years would be $4,159 – an increase of $603 per month.

– An Interest Only facility can be more stressful for some borrowers who like to see some gains for all the money they pay out in interest as the amount they owe their lender does not decrease.

Our take

– This is the same as our view for variable and fixed rates.

– While lower repayments for an Interest Only facility can seem intuitively better as you reduce the impact on your monthly cashflow, you are also delaying the repayment of the principal and so you are paying more in interest. For some borrowers, this trade-off is worth it as it allows them to enter the housing market and get started; or, it allows them to maximise the benefit of potential tax advantages if they are an Investor (again, seek independent tax advice on this issue).

– As with our comments on variable and fixed rates, it is important to note that everyone is different and everyone’s appetite for risk is different so there is no ‘one answer is correct’ advice. And, when you are dealing with joint applicants, you need to take into account the risk profile of each applicant. Just because one applicant might be comfortable with a higher level of perceived risk, the other applicant might be a little bit more conservative; so you need to balance the attitudes of both applicants.

– As part of our due diligence when we assist you in identifying a suitable loan, we undertake a Needs Analysis for each person applying. We ask you what your level of concern is about rising interest rates. We also ask you if you would like to consider a fixed rate loan, either in part or in full, and we go through with you all the features, pros and cons.

– We always ask ’Who is on your team?’. What we want to know is, have you got a great team of advisors to assist you in making important decisions? Because when you are dealing with loans of hundreds of thousands of dollars, you need knowledgeable, ethical professionals advising you of your risks.