Make sure the mortgage fits

You’ve worked hard to save your deposit, so do your homework to make sure the mortgage fits.

Very few people can afford to buy a home just with the cash in their bank or under their mattress. (If you can, crack open the champagne and stop reading). Nearly everyone will need to borrow money from a lender to get onto the property ladder.

This means choosing from hundreds of different mortgage products on offer.

Before you reach for the headache tablets, take heart - 85 per cent of all mortgages sold in Australia are variable rate mortgages of one kind or another, while 10 per cent are fixed rate products.

So a good starting point is familiarising yourself with the mechanics of fixed and variable rate mortgages.

Both are “principle + interest” type loans. You borrow a sum of money from a lender to buy your home and make regular repayments of this principle amount plus the interest charged until the loan is payed off.

The key feature of any variable rate loan is that the interest rate, and hence your repayment amount, adjusts as the official cash rate (the interest rate set monthly by the RBA) changes.

Fixed rate loans, on the other hand, offer an interest rate unchanged for the period of the loan (usually one to five years, but they can be as long as 15 years) regardless of what happens to the cash rate.

“Because it is absolutely predictable, the fixed rate home loan can give you greater confidence that you can meet your mortgage repayments regardless of changing economic conditions,” explains Phil Naylor, CEO of the Mortgage and Finance Association of Australia (MFAA).

As for variable rate home loans, Naylor says their advantage is that if official interest rates fall, the variable rate home loan can save you money, “but you need to consider the risk that your mortgage payments could rise in the future”.

As an example, having a variable rate mortgage was extremely advantageous during the financial crisis when the official cash rate more than halved in the space of a year. Fixed rate borrowers however were left shaking their fists in frustration - they saw no reduction in their mortgage repayments.

Some lenders offer a special low introductory interest rate - often called a “honeymoon” rate - for an initial period of the mortgage. While this will save you money initially, Naylor says you must find out what the rate will be when the honeymoon is over. “The lowest initial interest rate doesn't always mean the better deal,” he warns.

Choosing whether to fix or go variable is not just a matter of being an expert at forecasting future interest rate movement.

There are other things to keep in mind – variable rates generally offer greater flexibility and more features while fixed rate loans may have a higher interest rate, can include rigid contract terms and the cost to break the mortgage and refinance into a variable loan can be very high.

Both have benefits and disadvantages and their suitability will depend on your own situation and financial priorities.

But it doesn’t have to always come down to a clear choice between one or the other. Some lenders allow you to hedge your bets by taking out a split loan where a portion of the loan is fixed and a portion variable.

“The split rate home loan gives you some of the benefits of both fixed rate and variable rate loans. You won't save as much as a full variable rate loan if interest rates fall, but neither will you be as exposed if interest rates rise,” Naylor says.

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