Borrowers assume that picking the wrong lender is of greater importance than selecting the wrong product, but they would be wrong. Lenders tend to offer a similar range of products varying ever so slightly on cost, whereas loan products vastly differ in terms of features, discounts and flexibility.
A borrower should first decide which type of product is best suited for their needs and then go and find a lender who provides the best deal for that particular product. Most typical loan products include:
- Line of credit
- Basic variable
- Standard variable
- Discount variable
Line of credit (LOC)
Several borrowers will opt for a line of credit as it’s recommended by several financial experts but it is not usually the most cost-effective approach. LOC products tend to offer the most flexibility, however, this flexibility comes at a cost. LOC’s do not have a loan term which means there are no scheduled monthly repayments apart from interested accrued.
Think of an LOC as a loan account merged with a regular current account. Borrowers are able to use a ATM machine to withdraw money from their LOC, while being allowed to deposit their monthly salary into the same account.
As mentioned in our Line of Credit – Should you Get One? article, an LOC is most suited for property investors who need to take out smaller sums of money on a regular basis. For example, when renovating a property, several small purchases will need to be made over the course of several weeks. Using a card or going to the ATM is a much more convenient way of doing this and simpler to track costs.
As the name gives away, a basic variable is a typical no-frills package available from most lenders, offering very little in the way of features. However, they do offer redraw services but they tend to come at a high price and the minimum redraw amounts are usually set pretty high. Nearly all basic variable loans will have some sort of break cost, this is due to the small margins lenders make when offering this product to borrowers. Utilising break costs acts as a safeguard for lenders to ensure they will make a profit from this product by forcing borrowers to stick to the plan or pay heavily to opt out.
Upsides to basic variable loans include offering interest rates of around 0.60% lower than typical standard variable rates. Suited mostly for investment property loans where the investor wants to set and forget. Investors will set up monthly repayments to repay the interest and never touch the loan again.
Tip: Various lenders will offer a basic variable product as a partof their professional product range, meaning the borrower will not incur any application or ongoing fees. Note: Not all basic variable package will provide the borrower with interest-only repayments.
Of all the variable packages available, a standard variable will offer the best incentives. The most effective way to utilise a standard variable loan is when combined with a professional package to reduce the interest rate to be on par with basic variable loans.
These usually work in the same way as a standard variable except for the first 12 months they offer an added discount, hence the name. Lenders try to lure borrowers by offering them a great discount for the first year before locking them up in higher rates for the following years. Remember the goal is to secure the lowest ongoing interest rate and not to look for short-term discounts as they always come at a cost.
Borrowers shouldn’t expect after the first year they can change lender and reap all benefits without backlash. Nearly all discount variable loans have break costs if deciding to leave within the first 5 years. This reduces flexibility and locks borrowers in for the long-term.
We don’t recommend anyone choosing a discount variable product unless they intend to sell their property within a year. Before doing so, ensure there are no break costs involved or they are minimal to make this package worthwhile.
Fixed-rate products are pretty easy to understand. The borrower sets an agreement commonly between 1-5 years, then each month they pay back the agreed amount discussed with the lender. The amount does not change within the time period agreement regardless of interest rates going up or down.
Most fixed-rate packages will not allow you to make extra repayments without incurring a fee, nor can you increase or decrease the amount you pay back each month. The biggest drawback with fixed-rate loans is flexibility. Once settled, the borrower is locked in for the agreed upon number of years and will face heavy break costs if they decide to leave.
Upsides include knowing how much outgoings will be as borrowers know what their mortgage repayments are going to be each month. Fixed-rate packages are ideal for borrowers who do not plan to pick up and leave or sell their property in the near future. Most commonly used by investors who are using the buy and hold approach.
Similar to an LOC in some regards, an offset account is a regular loan account merged with the borrower’s current account. Interest is worked out by the net balance remainder after combing both accounts together. For example, if the loan balance is $150,000 and the current account holds $25,000, the borrower would be charged interest on the net balance of $125,000.
Typically used by homeowners living in their own properties as they can utilize any free cash they have to offset the amount of interest paid. To make the most of an offset account, place all incoming money directly into the account to reduce fees. We only suggest using an offset package when combined with a professional package to be eligible for discount interest rates of at least 0.50% compared against the standard variable.
How to choose the right product
- Requirements – Firstly, borrowers need to be realistic about what they actually need from a loan. The more features provided, the greater the cost. There’s a big difference between ‘must have’ features compared to ‘that would be cool’ features. For example, many like to have the option of redrawing, but very few will make large extra repayments on top of the current monthly fees. Remember, most redraws only allow the borrower to redraw to the total amount of their extra repayments. For a borrower who is only going to make 1 or 2 extra repayments a year, it may not be a feature worth paying for.
- Strategy – The type of loan needed for a buy and hold property (long-term strategy) will differ from a quick flip (short-term strategy). For the former, borrowers may want to opt for a fixed-rate or offset loan, compared to flipping where an LOC or a discount variable with minimal break costs would be better suited.
- Capital growth – Break costs can be the biggest crutch to earning decent capital growth. For example, buying a property in a high capital growth area can substantially increase the value of a property in a short space of time. If a borrower would then like to increase the loan term to take advantage of this a few years down the line, they may hit a brick wall due to break costs. Make sure to ask the lender in detail about all break costs associated with each package to avoid shocks later down the line.
- Is it flexible? – Property investors sometimes go for the buy and hold approach but a few years down the line their circumstances change and they need to sell. It’s critical to maintain as much flexibility with loans and reduce costs where possible when breaking them.
Don’t get tricked by lenders
Lenders typical advertise LOC’s and offset products as a way to save thousands of dollars for a borrower. The product itself does not save the borrower a single cent and savings are totally reliant on how the borrower manages their product. Several packages, aside from the two mentioned above, allow borrowers to make extra repayments when they see fit which negates some of the benefits of an offset or LOC product.
Don’t pay extra for such products solely to rely on ‘potential’ saving that may never come. For anyone who has the means of acquiring an LOC or offset loan while achieving the same interest rate as a basic variable loan, that’s awesome. But, for many, this will be a very difficult task to achieve and they would be better going with cheaper alternatives.
Remember, the key component to choosing the right loan is to understand the right product based on the borrower’s needs. Once found, find the lender offering the best deal for that type of package based on the criteria outlined in this article.
**This information is not intended as advice and should be viewed as general information only.