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Types of mortgages and how they work
Fixed against variable, principal and interest against interest-only, offset accounts, and what the interest actually costs.
A mortgage is a loan secured against the property, repaid over a term that is usually 25 or 30 years. Two choices define its shape: what kind of interest rate it carries, and what your repayments are made of. Everything else is features.
Fixed or variable
Fixed
The rate is locked for a period, typically one to five years. Repayments are predictable and a rate rise doesn't touch you. In exchange you usually can't make unlimited extra repayments, an offset account may not be available, and breaking the loan early can carry a substantial break cost. When the fixed term ends the loan reverts, often to a rate you wouldn't have chosen.
Variable
The rate moves with the market and your lender's decisions. You can make extra repayments, use an offset account, and refinance without a break fee. The cost is uncertainty: a rise lands on your next repayment.
Split
Part fixed, part variable. Some certainty, some flexibility, and the usual answer for people who can't decide. It also halves the size of the mistake either way.
Principal and interest, or interest-only
A principal and interest repayment does two things: pays the lender for the money, and reduces what you owe. An interest-only repayment does only the first. Your balance at the end of an interest-only period is exactly what it was at the start.
Interest-only is mostly used by investors maximising cash flow and deductible interest. For someone buying a home to live in, principal and interest is almost always right, and lenders price it more cheaply.
What the interest actually costs
Early in a loan, almost all of your repayment is interest, because interest is charged on a balance that is still nearly the whole purchase. The principal share grows year by year. The totals surprise people:
| On an $800,000 loan at 6% over 30 years | Amount |
|---|---|
| Total repaid | $1,726,706 |
| Of which principal | $800,000 |
| Of which interest | $926,706 |
Features worth having
- Offset account. A transaction account linked to the loan; its balance is deducted before interest is calculated. $20,000 sitting against a $300,000 loan means you're charged interest on $280,000. Your salary can live there. It is the single most useful feature for most owner-occupiers.
- Redraw. Extra repayments you can take back if you need them. Similar effect to an offset, but the money is legally the lender's until you redraw, and access can be restricted.
- Extra repayments. Usually unlimited on variable loans, often capped on fixed ones.
- Portability. Take the loan with you to your next property without refinancing.
Features cost something, usually in the rate or an annual package fee. An offset you don't keep money in is a fee for nothing.
Who you borrow from
- Banks. The widest product range and the most branches. Often the strictest assessment.
- Credit unions and mutuals. Frequently sharper rates and better service; a narrower range of products.
- Non-bank lenders. More flexible with unusual income or credit history, generally at a higher rate.
- Mortgage brokers. Not lenders. They compare across a panel and handle the application, usually at no cost to you because the lender pays them. Ask which lenders are on their panel, which aren't, and how the commission varies between them.
Before you move on
- You can explain fixed against variable in your own words
- You know what an offset account does and whether you'd use one
- You've seen the total interest on a loan the size you're considering
- You know what to ask a broker about their panel and their commission