The Pros and Cons of Different Types of Home Loans
When it comes to getting a mortgage, there’s a number of different loans, each with pros and cons. Then there’s the type of interest rate to consider.
It’s beneficial to choose the home loan and interest rate type that best suits your personal circumstances and financial situation. This decision can impact on how much the loan costs and the time it takes you to pay it off. It’s beneficial to get professional advice - our team can help you with this and for 99.9% of the time, there is no charge for using us.
Here we provide an overview summary, so you can gain a better understanding of the options.
TYPES OF HOME LOANS:
Table Loans
These types of loans are the most common and with most lenders, you can select up to 30 years as the term for how long you’ll take to repay the loan. A table loan means you’ll have regular repayments at the same time (at the frequency you choose weekly, fortnightly or monthly). The repayment amount only changes if the interest rate changes. Table loans can have fixed or floating interest rates.
These loans are great for budgeting as you have a set amount to pay, at set timeframes and you’ll know when the loan will be paid off. Those that have irregular income, however, may find the fixed regular repayments challenging.
Offset or Offsetting Loans
This type of loan can reduce the amount of interest you pay on your mortgage, given the interest is typically payable on the full amount of your loan. This is achieved by ‘offsetting’ or subtracting for the purposes of calculating interest, your savings or everyday accounts you have from the amount you still owe on your loan, meaning you’re paying interest on a lesser amount. This type of loan has a floating (or variable) interest rate. For example, if you have a $600,000 mortgage and you offset $30,000 savings and cheque account balances, you’ll only pay interest on $570,000 of your home loan. Interest is calculated daily, so the more cash you keep across your account from day to day, the more you’ll save!
The main pro of this type of loan is you pay less in interest and you can pay off your mortgage faster. The flip side is you don’t earn credit interest on your savings linked to this loan. And given the rate is floating, it can fluctuate, which means if the interest rate goes up, so too do your repayments.
Reducing (Balance) or Non-Table Loans
This type of loan is not that common in New Zealand. While your regular repayments of principal and interest are initially higher than other types of loans, your principal repayments remain the same, but your interest payments will reduce (in a straight line) over time.
The pros of this type of loan mean you’ll pay less interest over the life of your loan than a table loan. This is also a good option for those that know their income will decrease in the future, for e.g. you plan to stop working or reduce your hours in a few years.
The main con is higher initial repayments mean this home loan is more expensive in the short to medium term.
Reducing (Balance) or Non-Table Loans
Or revolving credit as it’s often referred to, helps save on interest by reducing your daily loan balance as much as possible. In essence, it’s like a big overdraft. Your income (e.g. pay) goes directly into this account and bills and everyday expenses are paid from this account when they’re due. The goal is to keep the loan as low as possible at any time, so you can pay less interest given lenders calculate interest daily. These types of loans have a floating (or variable) interest rate.
If you’re budget conscious, organised and good at managing your finances this type of loan is good for you as you can pay your home loan off sooner. You also have the flexibility of making as many lump-sum payments as you like, and then have access to that loan to redraw up to your limit at any time.
The disadvantages include the usual bank fees tend to apply to these transaction accounts so you may be charged for things like deposits, withdrawals, setting up an automatic payment etc. Also, you need to be disciplined. As seeing the money available and being able to access it is very tempting! If you continue to borrow up to your credit limit, you’ll end up paying interest on the full loan amount year after year.
Interest-only Loans
As the names suggest, this loan is where you only pay the interest part of your loan, not the principal, meaning the payments are lower. You don’t have to repay the principal until an agreed time. Often people who have an interest-only loan then switch to a table loan a year or two after.
The interest payments are at a regular frequency: weekly, fortnightly or monthly.
One of the great pros of this option is you’re paying less, as you’re not paying off the principal yet, so you have cash available for other uses. However, in contrast to this you end up paying more interest over the life of your loan. You still owe the full amount that you borrowed until the interest-only period ends and then you start paying back the loan. So it ends up costing you more.
TYPES OF INTEREST RATES
While some types of loans you can choose which interest rate type you’d like, for others as described above, they come with a floating (or variable) interest rate. Below we provide a summary of the different types of interest rates.
Fixed Interest Rate
This means for your home loan, the interest rate is fixed for a period of between six months to five years. Once you reach the end of the chosen term, you can then choose to refix or move to a floating (or variable) rate.
This option is ideal for budgeting as you know exactly how much your repayments will be. This option is also competitive with lenders, so you can often lock in a good rate. Unfortunately, with this option, there’s generally limits on how much you can raise repayments or make extra payments without incurring charges
Floating (or Variable) Interest Rate
This interest rate is changeable as it’s based on wider market changes, normally linked to the Official Cash Rate (OCR). This means your repayments may go up or down. This type of rate offers flexibility though, as you can pay off the loan sooner or change the loan term etc without incurring charges.
Historically, floating interest rates, however, have been higher than fixed interest rates. And some find that when the repayments go up, it makes it quite tight and difficult to manage their budget.
A combination of both types
You can have a combination and split your home loan between fixed and floating interest rates. This is a great way to have the assurance of the regular fixed rate repayments which is great for budgeting, but the flexibility of the floating rate and ability to pay that loan off sooner with extra repayments without being charged to do so.