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So, you’re thinking of buying a new home or investment property. You’ll start by reading a few blogs, download a podcast or two and ask your friends for some tips and advice. Throughout the process, you’ll start to hear terms like the loan to value ratio (LVR), stamp duty, rental yield, capital gains tax and the property bubble to name a few. So what do they all mean?
In this seven part ‘What Tha’ series, I’ll break them down into everyday language and provide common scenarios for you. Today, we start with part one, Finance. So grab a latte and let me explain…
Mortgage Broker: Mortgage Brokers get paid a commission by the banks or credit unions to find you a loan. Typically their commission is about $10,000 depending on the size of the loan and then a residual every year thereafter (about $1,000) whilst you hold the loan with that bank. The benefits of a broker are they should source the market for you and find you the best deal based on your circumstances. Check out our blog on Mortgage Brokers here and how to find the best one for you.
Loan to Value Ratio (LVR): This is the loan amount in relation to the price of the property. For simple math, if you want to buy a property for $500,000, the bank will say you need to have a 20% deposit. That means you need to have $100,000 saved ($500,000 x 20% = $100,000) and your mortgage will be $400,000, so the Loan to Value ratio is 80%.
Deposit: The savings you need to have in the bank. At the moment the banks like you to have a 20% deposit, however, you could secure a mortgage with 10% and sometimes even 5% (you would generally incur higher interest rates for a 10% or 5% deposit). It’s all dependant on whether you’re buying an investment property, a place to live in, the interest rate, your employment status, residency status, wage and credit history. They also like to see evidence of this saved over a period of time, as opposed to a lump sum.
Guarantor: If you haven't been able to save a whole deposit, you can ask someone to go guarantor on the mortgage for you - it’s usually Mum and Dad. Here the bank will use the equity in their asset to cover your deposit shortfall to get you up to 20%.
It’s a paperwork transaction and once your property increases in value the bank will remove the guarantors. It’s important to note that the asset being used to guarantee your loan can be sold whilst being used - the bank will simply transfer the security to the new property. Make sure you talk to a lawyer here, it’s important both parties know exactly what they are getting into.
Lenders Mortgage Insurance (LMI): If you haven’t saved a 20% deposit, the banks will add LMI onto your mortgage. In short, they insure your mortgage and if you default they still get their money. It doesn’t mean you get a get out of jail free card, this only covers the bank, not the borrower.
The cost will vary depending on how much money you borrow and the size of your deposit. Most lenders allow the premium to be added onto your loan (AKA capitalising the interest) or it may also be paid upfront. A loan of $500,000 with a 10% deposit will incur about $8,000 (approx) in LMI.
Equity/Leverage: If you live in Sydney or Melbourne and bought smart, your home should be worth more than your mortgage. Say you paid $500,000 back in 2014 and borrowed $400,000, you’ve paid about $30,000 off the mortgage, so still owe $370,000.
Your neighbour - who’s property is identical to yours - just sold for $750,000, this means you have $380,000 in equity ($750,000 - $370,000 = $380,000). You can do a few things here, leave it and be happy or apply to increase your original mortgage and the bank will lend you money based on the new value of your home, usually up to 80% ($750,000 x 80% = $600,000 - $380,000. Equity = $220,000 that the bank will lend you, based on meeting their other lending requirements). You can use the equity in your home to buy another property. Remember it's always good to have a buffer in case the value of your property decreases.
Offset or Redraw Account: A mortgage offset account is a savings or transaction account linked to your home loan. In short, the bank will look at the balance of this account and offset your home loan against the balance of your offset account, reducing the interest you pay to the bank. For example, you have a $500,000 loan and you have $50,000 in your offset account. The bank will only charge you interest on $450,000, not $500,000. Read our full blog on it here.
Interest Rates: When you borrow money from the bank or any lender for that matter, they will charge you interest on the borrowings over the life of the loan. It’s how they make their money. Interest rates can be fixed or variable.
Variable Interest Rates: If you choose to have your interest rates variable it means they will move up and down in line with the RBA cash rate or at your lender's discretion.
Fixed Interest Rates: If you don’t like surprises in life, then you’ll probably pick fixed rates. This is where the interest is locked in for a period of time, usually three to five years. These rates will also be higher than the current variable rate.
Split Loan or 50/50: If your mates call you Switzerland then you can go halves and lock in 50% at a fixed rate and 50% at a variable rate. You can also play around with the percentages, 60/40 for example.
Comparison Interest Rate: The Comparison rate is used to show the true cost of a loan, it takes into account the fees and charges and the interest rate as a single figure so you know the true cost of the loan.
Pre-Approval: Before you start looking, you need to get pre-approval from the bank. This involves filling out the mortgage application forms and supplying all the required documents, once you have the pre-approval you can start shopping. The pre-approval generally has a six-month lifespan, however, can vary from lender to lender.
RBA Cash Rate: The Reverse Bank of Australia (RBA) is the governing bank, they contribute to the stability of the currency, employment and the economic prosperity and welfare of the Australian people, a big job! Every month the RBA meet to discuss the Official Cash Rate (OCR). The OCR is the term used in Australia and New Zealand for the bank rate and is the rate of interest which the central bank charges on overnight loans to commercial banks. In short, if the OCR goes up or down, so will your variable interest rate.
Cash Flow Analysis: A Cash Flow Analysis is where you look at your costs of holding a property like mortgage repayments, rates, strata, electricity, water, insurance Vs. the rent you will receive and any tax offsets. It will let you know how much you have or don’t have left after everything is said and done.
Interest Only Loan: An interest only loan is when you only pay the interest and not the principal of the loan. People do this to minimise their repayments and for negative gearing tax strategies, which I'll discuss in part 4, leasing a property.
Principal and Interest Loan: Is when you pay off the principal (the money you originally borrowed) and the interest (the money the bank charge you for lending the money) at the same time.
Principal: The principal is the original money you have borrowed.
Bank Valuation: You’ve finally found your dream home or investment property, you’ll need to order a bank valuation. They’ll make sure they think the property is worth what you do. The bank valuation would need to be the same or higher for your loan to be approved. If it comes in below your desired purchase price, then you will need to top up the difference with your own cash or simply move onto the next property.
If you purchase a property at auction no bank valuation is required as it’s a public forum and the property is worth what the property is worth when the hammer drops.
Break fee: Always read the fine print! Check your mortgage contract for the break fee, this is the fee the banks will charge you if you pay out your loan early. Back in the day they were big and made it hard for you to change banks, then the government stepped in and it’s not too bad now.
Bridging Finance: If you’re buying a property and you have not yet sold your existing property, you can organise bridging finance with your bank. As the loan title would suggest, it’s a bridge to get you where you need to be. The bank will loan you the money to purchase your new property for up to six months, 12 if you’re building a new home. You can make interest only repayments during the loan period and then a final payment of principal and interest once you sell your existing home. To note, the interest rates are usually higher.
Caveat: If you look to purchase a property that has a caveat over it, it means it can’t be sold! A third party has placed the caveat over the property to ensure they get the money they are owed. Your conveyancer will be all over this.
Repayments: The payments you make to the bank on a weekly, fortnightly or monthly basis to pay your loan back. To note, if you pay the loan on a fortnightly basis, you will repay it quicker.
Default: This is when you don’t pay back your agreed mortgage payments.
Bankrupt: If you default on your payments, the bank will take your assets (home etc.) and declare you bankrupt. It's not good, you can’t get a loan for seven years (and even then you’ll struggle), can’t be a director of a company and they usually confiscate your passport.
Next week we’ll decipher the terms used in the purchasing phase.
Milk Chocolate was founded seven years ago by Richie Ragel and Michael Cleary, to purchase residential and commercial property in Australia on behalf of our clients, looking for a home or investment property. To see how we can help you get in touch here.
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