May 22

Different types of home loans and how they work

Last month we talked about the hidden costs behind a property purchase price, this month I would like to briefly explain about the different types of home loans in New Zealand.

Fixed vs Floating/Variable rate

Most common types of home loans you can choose either a fixed or a variable also known as floating interest rates. There are also revolving credit facility homes loans and offset facilities, both of those home loans are on a variable rate.

Some clients might split the total lending amount into different types of home loans to suit their short term or long-term financial goals.

Let’s explain what the differences in between those home loan types and the benefit and disadvantages.

Fixed interest rate

A fixed interest rate means that you choose a fixed interest rate for a certain period of time, the available terms generally are between 6 months to 5 years. The loan repayment will not change during the period (term) of the fixed rate that you choose.

At the end of your fixed interest rate term, you have a choice to either choose a new one from the rates available at that time, or move onto a floating interest rate.

Benefits and disadvantages

  • Loan repayment certainty since your fixed interest rates will not be affected by the market interest rate changes during the fixed term period.
  • Fixed rates can be lower than floating rates.
  • If the floating rate falls below your fixed rate during the fixed term, you continue to pay the fixed rate.
  • You might have to pay an early repayment charge (ERC) if you want to make extra repayments or pay off the loan faster than initially discussed at the start of a fixed interest rate term.
  • ERCs may be higher for longer fixed rate terms. If you take out a longer fixed rate home loan (e.g. five years) which triggers an ERC later, you might have to pay more than if you were taking out the same loan over a shorter fixed term. *Please note that each bank have their own formula how to calculate ERC.

Most suitable for those clients who –

  • Would like to have certainty and security, or they believe interest rates may go up during the term, then choose a longer-term loan.
  • If they believe interest rates may go down in the short term, or if you are expecting a lump sum or selling a house in the near future, then they might choose a shorter-term loan.

Floating interest rate

A floating interest rate will change according to the wider interest rates market. When your home loan is on floating interest rate, you have a choice to switch into a fixed interest rate at any time, please be aware some types of home loans are only available with a floating interest rate.

Benefit and disadvantages

  • The flexibility to make lump sum repayments of any size at any time without penalty.
  • If interest rates go down, you might choose to pay off your loan faster by keeping the loan repayments at the same level.
  • As the rate is floating it can go higher than fixed term interest rates
  • If the interest rate goes up, your loan repayment will increase accordingly which might put pressure on your original budget

Offsetting loans

Offsetting loans, which means money sits in your eligible accounts all work together to help you pay off your home loan fast and potentially save your total interest costs. You will only pay interest on the difference between what’s in those accounts and the balance of your floating. This type of home loan has a floating (or variable) interest rate.

Benefits and disadvantages

  • If you regularly have money in transaction or savings account you can save on interest and pay off your home loan faster, and if you are fully offset you can pay no interest.
  • As the rate is floating, it can go higher than fixed term rates and if the interest rate goes up, so will your repayments.
  • You normally don’t earn credit interest on your savings.

Revolving credit facility / home loans

A revolving home loan combines your home loan and everyday spending into one account. There are no set repayments, but your balance needs to stay within the limit at all times. This means that your balance may fluctuate up and down depending on your spending habits. For this type of loan you are only paying interest on the balance of your loan, not your total limit.

The interest is calculated on the daily balance of your account and deducted interest every month, so by keeping the loan as low as you can and for as long as you can, you should pay less interest.

Benefits and disadvantages

  • If you are disciplined with your budget and manage your accounts well, you will repay your home loan sooner.
  • There is an option of making as many lump-sum repayments as you like (each time you are paying a lump sum it means you are paying down your loan’s principal), and the most beneficial part is that you can redraw the loan later if needed (as long as it is within the limit)
  • A very helpful tip to save on interest is by putting spare money into this account instead of a savings account.
  • However, if you keep the balance to your max credit limit, you’ll end up paying interest on the full loan amount year after year with a floating home loan rate,
  • It operates like a transaction account, so there will be the usual bank fees apply, subject to each bank’s fees guide.

Interest-only loans

An interest-only home loan can be an option when you need a home loan, but don’t want to pay off the principal (the original amount you borrowed) just yet. They’re often used for investment properties or for borrowers who wish to have a smaller loan repayment start with before full principal and interest payment kicks in.

With this type of home loan, you don’t repay any of the loan principal you’ve borrowered until an agreed time, you will only need to make regular interest payments every week, fortnight or month. After that, you can choose to switch to principal and interest payments.

Benefits and disadvantages

  • Because you’re not repaying principal, you can free up cash for other purposes, such as renovations.
  • You pay interest on the full amount you borrowed until an agreed time because you are not paying off any principal — then you still have to repay the loan amount (or you might for example request to switch to a table loan).
  • An interest only loan will cost you more interest in the long term than a table or reducing loan because you’re not paying off any of the principal during the interest only period.
  • Because you still must repay your loan before your maturity date, your repayment amounts after the interest only period ends will be higher. Interest only loans are only available on a short-term basis to ensure you can still pay down the loan before your maturity date.
  • Most lenders treat interest only applications as a full lending application as they would like to ensure that after the end of interest only period, with the remaining loan term clients are still meeting bank servicing ability requirement comfortably with the full principal payment and interest payment.

In summary, understanding the different types of home loans and discussing home loan structure options are a very important step in the whole mortgage application process, we are always here to help.

* Disclaimer: We recommend that you seek personalised professional advice from your trusted adviser before taking any action as each applicant’s situation can be vary, the above content is only general commentary.