- Interest rate: This can be fixed for an agreed time (ranging from six months to five years) or variable (floating) as market interest rates go up and down
- Mortgage term: How long you have to completely repay the loan, which can be up to 30 years
- Repayment structure: How much of your regular mortgage repayment goes towards repaying the amount owing, as opposed to the interest due each time, and whether you can make extra repayments without penalty or redraw some of the money you’ve already repaid
- Offsetting: Allowing money in other bank accounts to reduce your mortgage balance, so that you pay less interest
Fixed interest rate
The interest rate on some mortgages can be kept the same for an agreed period of time. Different periods typically have different fixed rates, so you’ll hear people talking about the ‘one-year fixed rate’, or a ‘two-year fixed rate special’ and so on.
As your fixed rate period comes to an end, you can choose another one from the mortgage rates available at the time. If you do nothing it will change to the variable rate, until you ask the lender for a fixed interest rate. Either way, your regular mortgage repayments could increase or decrease at this time, depending on the new rates available.
The main advantage of a fixed interest rate is certainty. For the interest rate period you select, you’ll know exactly what your regular mortgage repayments will be. If advertised interest rates increase while you’re fixed, you’ll have the advantage of being on a lower rate, at least until your fixed interest rate period ends.
A potential disadvantage with fixed interest rate mortgages is you’re contracted to make those exact regular repayments, and no more, for the agreed fixed rate period. That means you can’t increase your regular repayments, make lump sum repayments, pay off your loan entirely or change lenders while it’s still on a fixed rate. If you do, the lender will probably charge you an early repayment penalty, particularly if fixed rates have decreased. This penalty is calculated to cover what the lender will lose by having to relend the money you’re repaying earlier than agreed. However, some lenders do let you increase your repayments by a small percentage each year without penalty, so be sure to ask. If interest rates fall while you’re fixed, that’s another potential disadvantage.
Variable interest rate
A variable (floating) interest rate, can increase or decrease at any time as market interest rates change, particularly the government’s official cash rate (OCR). This means your regular mortgage repayments can change.
The main advantage is flexibility. With mortgages on a variable interest rate, you only have to pay the agreed regular minimum plus interest. You’re free to increase your regular repayments, make lump sum repayments, pay off your loan or change lenders whenever you choose. Repaying your mortgage faster can significantly reduce the total interest you pay over the life of your loan. It also means you get to enjoy a mortgage-free lifestyle sooner. The other advantage occurs if interest rates fall. You won’t be left on a higher fixed rate and you can change to a more attractive low fixed rate if you wish.
The main disadvantage of a variable interest rate is they tend to be higher than the fixed interest rates at any time. Also, if interest rates rise your regular repayments will increase. While you can change to a fixed rate at any time, the fixed rates may also be higher than they were before.
Choosing a mortgage term
The term of a mortgage is the maximum amount of time you have to fully repay the amount you borrowed. Terms typically range from 10 to 30 years, in five-year intervals.
The longer the term, the less principal (amount owing) you have to repay each time. This reduces your regular fortnightly or monthly repayments, making the mortgage more affordable to begin with. However, the slower you repay the amount owing, the more interest you’ll pay each time and you’ll be paying interest for years longer. This can add a significant amount to the total cost of your mortgage over its lifetime.
Many people start out with a long mortgage term, to be sure they can afford the regular repayments. As their income grows, or other expenses such as a student loan reduce, they shorten the term by increasing their regular repayments. If they run into financial difficulties or reduce to one income for a while, they may be able to extend the term again to help see them through.
See our guide on a how to pay off your mortgage faster.
This is the most common type of mortgage. It can have a fixed or variable interest rate. Your regular repayments are initially calculated to be the same each time and to ensure your mortgage is fully repaid by the end of the chosen term. Whenever your interest rate changes, the calculations are done again to achieve the same goals. So your regular repayments will go up or down accordingly.
To begin with, your regular fortnightly or monthly repayments are mostly paying the interest owed each time and repay very little of the amount you borrowed (principal). Gradually as you repay some of the principal, the amount of interest charged decreases, so your regular repayments repay slightly more principal. Towards the end of your mortgage term, your regular repayments are almost entirely repaying principal and the amount owing rapidly decreases.
Although this type of mortgage can take longer to repay than some others, the main advantage is the initial repayments are more affordable and reasonably consistent, apart from changes in interest rates.
These mortgages are quite rare and typically only suit people who can afford high repayments initially, but expect their income to reduce in the near future. An example would be a couple nearing retirement, where one of them will be stopping work in about five years.
With a reducing mortgage you repay the same amount of principal (the money you borrowed) each time. Your interest repayments start on the full loan amount and gradually reduce as you repay more and more principal. As a result, your regular fortnightly or monthly mortgage repayments steadily decrease.
This means you pay much less interest overall, compared to a table mortgage over the same term. However, most people who can afford higher initial repayments would save even more by continuing to pay that amount with a table mortgage.
As its name suggests, with this type of mortgage your regular fortnightly or monthly repayments only pay the interest owing each time. That means you don’t repay any of the amount you borrowed (principal) and keep paying interest on the full amount. The main advantage is that you’ll have the lowest possible regular mortgage repayments.
Interest-only mortgages are typically only suitable for property investors, who want to keep their costs down while they renovate a home to add value or until they resell. These mortgages may also suit some first home buyers who are certain they’ll have significantly more income or fewer expenses in a couple of years’ time. When that time comes, they can change to a normal table mortgage with its much higher regular repayments.
The maximum term for an interest-only mortgage tends to be only five years. After that they usually revert to a table mortgage, although you could apply for another interest-only mortgage and see what the lender says. Because you’re not repaying any of the principal, lenders are often reluctant to approve interest-only mortgages, in case property values drop and the home ends up being worth less than the amount you owe.
With these mortgages you can link savings and everyday transaction accounts with the same lender to your mortgage. The total amount in the linked accounts is subtracted from your mortgage balance before the interest is calculated. The interest is calculated daily and paid monthly, so the more you have in the linked accounts and the longer you leave it there, the less interest you’ll pay.
Having your income paid into one of the linked accounts immediately puts it to work, reducing your interest. If you make most of your day-to-day purchases using a credit card and only repay it in full at the end of the interest-free period, you’ll save even more. Some lenders let your close family members link accounts to your mortgage as well. These family members keep sole access to the money in their account, but it helps reduce the interest you pay on your mortgage each month. They can also unlink their account whenever they want to.
The main disadvantage of offset mortgages is they can only have a variable interest rate. These are usually higher than fixed interest rates and don’t offer the same certainty. The other disadvantage is the money in the linked accounts doesn’t earn interest; however the interest avoided (saved) by offsetting will always be greater than the interest lost by not having the money in a savings account.
People often split their borrowing between an offset mortgage and a fixed mortgage. They make sure the size of the offset mortgage is close to what they expect to have in the linked bank accounts, so the higher and variable interest rate has a minimal downside. There’s more about splitting mortgages below.
As you repay your offset mortgage, you may end up with more in your linked accounts than the remaining mortgage balance. If so, one or more of the accounts can always be unlinked, perhaps a close family member’s account, so they start earning interest again.
Revolving credit mortgage
These mortgages offer maximum flexibility, but only suit people who are very disciplined when it comes to managing their money. Here’s why:
A revolving credit mortgage is like a large overdraft facility. You agree to a maximum borrowing limit, then you’re free to draw down (withdraw) or repay money as often as you choose. The interest is calculated on the daily balance and paid monthly from the same mortgage account.
A revolving credit mortgage operates just like a normal transaction account; you can access it using EFTPOS, ATMs, internet banking and so on. In fact, most people use it as their everyday account. They pay their income directly into it to reduce the balance owing. They also keep the money there for as long as possible, by paying for things on a credit card and only repaying that in full at the end of each interest-free period. It’s a great way to save on interest and even small savings can really add up over the life of the mortgage.
Revolving credit mortgages can also be particularly suitable for people with an irregular income, such as freelancers, contractors and seasonal workers. You don’t have to make regular mortgage repayments and when you receive income it can be immediately used to full effect, reducing the balance owing and interest charged.
The freedom to easily draw down money can also suit people who’ve bought a home with value-adding renovations in mind. They don’t have to start paying interest on the money required until they make the purchases or pay the invoices involved.
The main downside with revolving credit mortgages is the temptation to spend up rather than repay the amount you owe. The higher your loan balance each day, the more interest you’ll be charged each month, which is simply added to the loan. Some lenders offer revolving credit mortgages with a decreasing limit. This effectively adds a term to the mortgage and can help to keep you on track to repay your mortgage as planned.
Like offsetting mortgages, another downside of revolving credit mortgages is they only come with a variable interest rate. This allows you the freedom to deposit and withdraw up to the limit at will, but variable rates are typically higher than fixed rates and they can increase, or decrease, at any time.
A big difference between offsetting and revolving credit mortgages is the latter is an all-in-one account. With offsetting mortgages, your money is in separate accounts and potentially easier to keep an eye on.
Only available for people over 60 who own their home outright, these mortgages require no regular repayments at all. They’re designed to help older people, who no longer have the income to repay a normal mortgage, access some of the value in their home without having to sell and move on.
The interest charges are simply added to the loan, which compound and grow at an increasing rate until the borrower downsizes to another home, moves into full-time care or passes away. The proceeds from selling the house are then used to repay the eventual balance, including the accumulated interest, which can be quite substantial. The remainder is paid to the borrower or their estate.
To ensure the value of the home will always be enough to repay the final amount owing, you can only borrow a percentage of the home’s value at the time of taking out the mortgage. The younger you’re, the smaller the percentage you can borrow because the amount owing is likely to grow for longer. It’s typically 15% at age 60 and rises steadily to 45% at age 95.
With all mortgages, and particularly reverse mortgages, it’s very important to seek independent advice from your solicitor to ensure you understand what’s involved before signing anything.
See our in depth guide to reverse mortgages.
Split or combination mortgages
Most people split their borrowing between two or more types of mortgage. Done well, it can greatly reduce the interest you pay over the life of your loans. It can also help to reduce the risk of having your entire mortgage in what turns out to be a less favourable type. It pays to get experienced advice to identify the options that might suit your current and future circumstances.
Combinations might include:
- One-year fixed plus three-year fixed rate table mortgages – to reduce the impact of interest rates being high when a fixed interest rate period ends
- Variable plus fixed rate table mortgages – to let you make some repayment increases without an early repayment penalty and also have the certainty of a fixed rate
- An offset mortgage plus one-year and three-year fixed table mortgages – to take advantage of money in linked accounts, while also enjoying typically lower fixed rates, more repayment certainty and reduced risk for most of the borrowing
Putting it all together in an example
A temporary boost from ‘the bank of mum and dad’
Best mates Nat and Sarah were well into their 30s and keen to get a place of their own so they could put their DIY and interior design skills to work. They combined their savings and had enough for a deposit on a modest two-bedroom unit. Both had stable and reasonably well-paying jobs, and although they could afford the mortgage repayments, there would be almost nothing left over for renovating.
Neither set of parents had money they could gift to Nat and Sarah, but they did have ‘emergency’ money in savings accounts earning a relatively small amount of interest. They were happy to link these accounts to an offsetting mortgage for the next five years or until an emergency occurred. Nat and Sarah offered to pay their parents the interest they would no longer receive, but they said they didn’t need it.
After paying the deposit, Nat and Sarah needed to borrow $500,000 to buy the unit. They split the loan between a $50,000 offsetting mortgage, a $200,000 one-year fixed table mortgage and a $250,000 three-year fixed table mortgage, all on 30-year terms to keep the initial repayments as low as possible.
Both sets of parents opened savings accounts with Nat and Sarah’s mortgage lender, each depositing $20,000 of their emergency money, so a total of $40,000. These accounts were linked to the offsetting mortgage, bringing the balance for interest down to $10,000. The variable interest rate was 8%, so the $40,000 offset would save Nat and Sarah around $3,200 a year.
Nat and Sarah had their incomes paid directly into their everyday accounts and linked these to the offsetting mortgage. They also opened a separate savings account for the future renovations and linked that as well.
Nat and Sarah knew they could afford the full mortgage repayments without their parents’ offsetting, if they had to. They worked out how much all the offsetting was saving them each month and set up an automatic payment for this amount into the renovation account.
Five years later they had completed some great value-adding renovations and their parents’ unlinked their savings accounts as planned. Nat and Sarah were now earning more than before and could make their own contributions to the renovation account. They couldn’t offset as much as their parents’ savings had, so they reduced the offsetting mortgage by $30,000 and took out an additional fixed interest mortgage for the same amount, but on a more attractive and consistent interest rate.