How should you structure your home loan? 1

A friend of mine is in the process of purchasing their first home and this has prompted me to write this post on structuring your home loan.

It is likely that your home loan will be the biggest debt you will ever acquire so the structure of this loan deserves some serious consideration.

If the property is for you to live in, then it is best if the loan is Principal and Interest (P&I).  This is likely to be taken out over 25 – 30 years to enable the repayments to be manageable.  But, you should be aiming to pay the loan off much quicker than 30 years, or you’ll be paying a heck of a lot of interest!

At the moment in New Zealand, house prices are high and interest rates are low.  This means that people are borrowing huge sums of money based on the cost of repayment today.  It is important to factor in the inevitable rise in interest rates in the next year or so.  Make sure that you can afford the repayments if (when!) interest rates rise, and if you are borrowing a large sum, split the loan into a variety of fixed terms so that not all of it rolls over onto a higher rate at the same time.  This helps to spread your interest rate risk.

I would suggest fixing some of your loan at the cheapest rate (probably 1 year), some at 3 years, and leave some floating so that you can pay this portion off as quickly as possible without penalty.

When selecting fixed terms, be aware that if you want to “break” or pay this off early, the bank will charge you break fees and penalties.  You agree to this when you sign the fine print in your loan document.

Make your repayments as frequently as the bank allows.  If you are paying fortnightly instead of monthly, then you get in at least one extra repayment each year.  If you can pay weekly, this is even better.

When shopping for a home loan, the bank offering the lowest interest rate, might not be offering the best loan for you.  Make sure that there are not hidden fees, onerous restrictions, or unreasonable break costs (the bank is allowed to charge reasonable costs to offset the cost they incur due to you breaking your loan).  Not all banks offer weekly repayments.  Some banks may add a Low Equity Margin (LEM) to your loan.  A LEM can be in the form of an increased interest rate, or it could be a one-off fee.  LEMs are usually applied to high LVR (Loan to Value Ratio) lending where you are borrowing more than 80% of a property’s value.

Don’t allow your choice of home loan to be swayed by the offer of an iPad, or flat screen TV.  The bank stands to make a lot of money off the interest from your loan.  The most important thing you can do is to get the right loan for your circumstances.

Consider your future plans.  Don’t fix your lending for 5 years if you intend to move house in 3 years.  Don’t fix all of your loan on the 4.95% 1 year rate if you know you can’t afford to pay the loan if rates rise to 7.00%.

Some banks allow you to pay more than the minimum repayment (up to 20% extra!) on fixed term loans.  If you can afford to do this, do it!  Paying a little extra will knock years off the term of your loan and also prepare you for any increase in repayments when interest rates rise.  If you set your repayments now based on an interest rate of 7%, then you’ll be paying your loan off faster, and when interest rates do hit 7%, you’ll already be managing this repayment in your household budget.

A couple of other types of home loan:

A revolving credit facility is effectively a massive overdraft.  The advantage of this type of loan is that any wages/salary deposited reduce the outstanding balance on the account and hence the interest charged.  The disadvantage is that it is a massive overdraft, and unless you are very disciplined, you might never pay off your loan.  This facility is great for an amount that you might be able to pay off in a short timeframe, say a year or two.  I imagine it would be pretty depressing to get an ATM balance receipt showing your balance as $457,942.00 OD, so don’t use this structure for your whole loan or you’ll never feel that you’re getting ahead.

An interest-only loan is useful for investors or developers.  It’s not a viable option for your own home.  The idea with this type of loan is that you (or your tenant) only pays the interest on the loan and the principal amount stays the same.  An investor or developer can offset this interest expense against any revenue generated from the property, so there is no real advantage in paying down the principal whilst they are growing their business.  Banks offer this option for 5 or 10 year terms, but generally you can negotiate to keep the facility for longer.  Why would the bank want you to pay down the principal anyway, they’re making more money off you in interest if you don’t.

David Tillman’s book “Hammer That Mortgage” might be a helpful read for those starting out with a large home loan.  (Even though we know that a “home loan” is not a “mortgage“).








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