Key Definitions & Concepts:
- Principal: This is the amount of money you borrow and are required to pay back. It is also the loan balance on which interest is calculated.
- Interest Rate: The interest rate is how much the lender charges you for borrowing the money, expressed as a percentage per year and generally calculated on a daily basis. It can be fixed or variable, with some loans offering a split rate; part fixed, part variable.
- Loan Term (Tenor): This is the length of time over which your loan is to be repaid (typically 25-30 years) and determines the size of your monthly repayments.
- LVR (Loan-to-Value Ratio): This is a percentage that shows the loan amount as a portion of the property’s value, calculated as loan ÷ property value × 100%. A lower LVR is better as it often gets you a lower rate or avoids extra costs, whereas if your LVR is higher (i.e. < 20% deposit), the lender will usually require Lenders’ Mortgage Insurance.
- Lenders’ Mortgage Insurance (LMI): Don’t be fooled by the name – this insurance protects the lender, not you. If your deposit is under 20% (LVR > 80%), the bank takes out an LMI policy to insure itself in case you default which is passed on to you as a fee (it can be thousands of dollars).
- Repayment Frequency: Home loans in Australia usually let you choose monthly, fortnightly, or weekly repayments.
negotiating loan terms
Principal & LVR
The amount you borrow forms the basis for calculating interest and repayments, as well as your initial LVR. Together, it is an important consideration when setting your deposit savings goals as they determine the total acquisition costs:
- LMI: If you save a deposit <20% (LVR> 80%), you may be subject to LMI on your loan, which can range from 1-3% of the loan amount.
- Interest: Saving for a larger deposit will reduce both your lifetime interest expense and monthly payments, so it is important to consider the trade-off between these savings and any capital growth you may forego by entering the market later.
Loan Term (Tenor)
A longer term means lower monthly payments, but more interest paid overall.
Often borrowers who know they could still service (pay for) higher monthly payments will still opt for a 30-year term and instead place any additional cash in an offset account or voluntarily repay the loan with additional payments. This provides flexibility as you don’t have to commit to the higher repayments and can still take advantage of other ways to manage your interest expenses.
Interest Rate
Fixed-rate period
With a fixed-rate loan, your interest rate stays the same for a predetermined period (e.g. 2, 3, or 5 years).
Considerations:
- Stability: Fixed rates provide predictable repayments, which can help with budgeting.
- Rate Changes: If market rates drop during your fixed period, you won’t benefit until the term ends.
- Break Fees: Exiting a fixed-rate period early (to refinance or switch loans) often incurs significant fees.
- Length: Consider how long you plan to hold the property; a longer fixed term can offer security but might limit flexibility.
Variable interest rate
A variable rate can fluctuate based on market conditions.
Considerations:
- Flexibility: You may benefit from rate reductions if the market improves.
- Risk: Your repayments could increase if rates go up.
- No Early Exit Fees: Exiting a fixed-rate period early (to refinance or switch loans) often incurs significant fees.
- Length: Consider how long you plan to hold the property; a longer fixed term can offer security but might limit flexibility.
Interest-only period
Some loans offer an initial interest-only period where you only pay the interest on your loan for a set time (e.g. 1–5 years).
Considerations:
- Lower Initial Repayments: During this period, repayments are lower because you're not reducing the principal.
- Long-Term Impact: Once the period ends, repayments increase significantly as you start paying off the principal along with interest.
- Investment vs. Owner-Occupier: Interest-only periods are common for investment loans, as they maximise cash flow initially, but they can also pose risks if property values drop or if income doesn’t increase as expected.
Example: Interest-Only Periods
Consider a $500,000 loan at an annual interest rate of 5% over a 30-year term is considered under two scenarios:
1. In the interest-only option, the first 5 years involve paying only interest, which calculates to about $2,083 per month (5% of $500,000 divided by 12), leaving the full $500,000 principal intact. After the 5-year interest-only period, the remaining $500,000 is amortised over 25 years, resulting in a new monthly principal and interest payment of approximately $2,922.
2. In contrast, a full principal and interest loan over 30 years has a consistent monthly payment of roughly $2,684.
Key Points:
Lower Initial Repayments: The interest-only period offers reduced payments ($2,083 per month) in the initial 5 years, easing cash flow early on.
Increased Payments Later: After the interest-only period, the shorter 25-year amortisation period significantly increases monthly repayments to about $2,922.
Overall Impact: While the interest-only option provides immediate cash flow benefits, it results in higher repayments later, which could lead to increased financial pressure once the principal repayment starts.
Repayment Frequency
Whether your repayments are monthly, fortnightly, or weekly can affect how quickly you reduce your principal and the total interest paid over time.
Increasing your payment frequency slightly reduces interest if your loan calculates interest daily (since your balance goes down incrementally sooner). In any case, it’s important to choose a frequency that aligns with your pay cycle and budgeting.
Monthly is the default, however some borrowers opt for fortnightly payments – paying half the monthly amount every two weeks results in 26 payments a year, which actually equals 13 months’ worth of payments every 12 months. This little trick can shave a few years off a 30-year loan because you’re effectively making one extra monthly payment per year without feeling it too much. Weekly payments work similarly (52 weeks = 13 “months” of payments in a year).
Example
Consider a $300,000 loan at 5% annual interest over 30 years, where the standard monthly repayment is about $1,610, resulting in total payments of approximately $579,600 and total interest of roughly $279,600.
Switching to fortnightly payments means paying $805 every two weeks, which adds up to 26 payments per year—an annual total of $20,930, equivalent to making one extra monthly payment each year; this extra payment accelerates principal reduction, potentially shortening the loan term to around 27 years and saving about $30,000 in interest over the life of the loan.
Offset accounts
An offset account is basically a regular bank account linked to your home loan, but with a special perk: whatever balance is in the offset offsets (reduces) the loan balance for interest calculation. In other words, the bank will only charge you interest on the net balance (loan minus offset).
For example, Alex keeps $100,000 of savings in his offset account. His loan is $400,000, but with the offset, he is charged interest as if he only owes $300,000. He’s still free to use that $100k in the offset anytime, but while it sits there, it’s working to save him interest.
Why not just pay down the loan?
-
Flexibility: Money in an offset account achieves the same interest saving as if you paid it straight off the loan principal – but it gives you more flexibility.
- If Alex put that $20k directly into the loan, he’d reduce the loan to $380k, but to get that money back he’d have to redraw it (which might have limits or delays). With an offset, the $20k is liquid – he can pull it out tomorrow if needed, while any day it’s in there, it’s cutting his interest. - Tax-free interest savings: if you put $20k in a normal savings account, you’d earn interest but have to pay tax on that interest. Using it to save mortgage interest effectively earns you a return at your home loan rate, tax-free.
Offset vs. Redraw
These two concepts are similar in that they both let you utilise extra money to reduce interest, but they work differently.
- Offset account: is a separate bank account (or accounts) linked to the loan.
- Redraw facility: is a feature that lets you pull out any voluntary repayments you’ve made on the loan.
The key differences are accessibility and flexibility. Offset money is instantly accessible whereas redraw, on the other hand, might require transferring funds from the loan to a savings account first, potentially with some notice or minimum redraw amounts (depending on the lender). Some basic loans even charge a small fee or have a limit on number of redraws.
Essentially, offset = your money at call, redraw = your money but held inside the loan.
Example
If Alex had no offset but a redraw facility, he could still achieve interest savings by paying an extra $20k into the loan (reducing the balance to $380k). Later, if he needs that money, he’d put in a request to redraw it (often online, which in practice can be quick, but it’s not as seamless as an offset withdrawal). Some lenders also don’t allow redraw at all during fixed-rate periods or have conditions.
making Voluntary Repayments
Voluntary repayments are extra payments made in addition to your minimum monthly mortgage repayment. They can help reduce your loan balance faster and save you money on interest over the life of your loan.
It’s a pretty straight forward concept in reality, however it is important to be aware of the following:
- Budget Impact: Ensure extra payments won’t strain your monthly cash flow and consider emergency savings before committing too much extra money.
- No Penalties (Usually): Paying fees for early repayments seems a bit counter-intuitive, but it depends on the current terms of your home loan. Most variable rate loans allow unlimited extra repayments without fees, however if you're on a fixed-rate loan, check for limits or early repayment fees.
- Flexibility: Extra payments directly reduce your debt, but once paid, they are not immediately accessible unless your loan has a redraw facility. Compare this with the flexibility offered by an offset account.
- Redraw Facility: Without a redraw facility attached to your home loan, you will not be able to access any of the voluntary repayments you make.
Example
Suppose your $400k loan over 30 years has a 6% interest rate. His minimum monthly payment is about $2,398. If he pays an extra $200 a month (about $50 a week), that’s an additional $2,400 per year. As a result, you would save around $60,000 in interest over the life of the loan and finish 4–5 years earlier than 30 years.
These savings are indeed significant, however it’s important to note that the benefit of voluntary repayments in the way this example depicts (small contributions over time) is weighted more so towards the tail end of the loan. For this reason, consider whether you intend to hold that property for this entire period to determine if this strategy is right for you.
Switching Lenders (Refinancing)
After a couple of years, Alex wonders if he should refinance – that is, switch his home loan to a new lender or a new loan product.
When and why to refinance:
- To get a lower rate and reduce your interest payments (most common).
- Switching from a fixed to variable rate (or vice versa).
- Splitting a single loan into two loans to diversify your interest rate risk between fixed and variable.
- Accessing additional features (maybe your current loan doesn’t have an offset and you want one).
- Consolidating other debts into the home loan.
- If your fixed period ending, prompting you to shop around.
- To pull out equity as cash for renovations or to fund another purchase (see the following Lesson).
- To shorten the loan term (e.g. going from 30 years to 20 years remaining) and force higher repayments to reduce debt sooner.
- To extend the term if you’re struggling and need lower repayments (though extending increases total interest).
Refinancing Fees
Refinancing to a lower interest rate can indeed save you thousands, but you must ensure the benefits outweigh the one-off costs of switching, which can include:
- Discharge Fee: A fee charged by your current lender to close your existing loan account ($100 – $300).
- Application/Establishment Fee: New lenders may charge a fee to process your loan application. Some lenders may waive this fee to attract new customers ($300 – $800).
- Valuation Fee: Your new lender will usually require an independent valuation of your property to confirm its market value ($200 – $600).
- Settlement/Legal Fees: These fees cover the administrative and legal work required to finalise the refinancing ($100 – $300).
- Government Fees: Mortgage registration and title transfer fees ($100-300).
- Break Fee (if applicable): Compensation for exiting your fixed term early (varies widely – potentially $1,000+).
Always compare not just interest rates but also comparison rates (which factor in typical fees) to ensure you’re truly getting a better deal. If it feels overwhelming, a mortgage broker can help you shop around and handle the process.
Things to Watch
1.
Always check with your current bank to see if they’ll offer a better deal. Often, if you tell your lender you’re considering leaving for a cheaper rate elsewhere, they might reduce your rate to keep you.
2.
When refinancing, avoid extending your loan term back out to 30 years again without careful thought. Some lenders default to a fresh 30-year term which lowers your payments but means you’ll pay more interest in total. You can request a shorter term on the new loan.
3.
Try not to borrow more than you need unless it’s for a clear purpose – some might be tempted to cash-out extra money for personal use, but that just increases your debt (more on cash-out below).
In summary, refinancing can be very beneficial. It is encouraged to review your home loan every year or two and negotiate or switch if the deal is no longer sharp. It’s your money – don’t be afraid to seek a better offer. Just be mindful of any costs to exit and enter, and any conditions like LMI or break fees that apply in your situation. If done right, refinancing can save you a bundle and possibly get you features more suited to your needs now to optimise your portfolio and accelerate its’ growth.
Withdrawing Equity (Cash-Out Refinance)
Over time, as you pay down your loan and/or as property values rise, you build up equity, which is the difference between the property value and the loan balance.
Equity = Property Value – Loan Balance
Many lenders allow you to withdraw on your equity through either:
1. Cash-out refinance: Refinancing to a higher loan amount and taking the difference as cash.
2. Home Equity Loan: Taking out a separate loan secured against your property, allowing you to borrow against your available equity without changing your existing mortgage.
Not all this equity is accessible as banks will often only let you withdraw the difference between your loan balance and 80% of the property’s value (with some exceptions that exceed 80% LVR). At ScaleApp, we use the following formula:
Equity Available = (Property Value x 80%) – Loan Balance
Practically speaking, you’ll still need to qualify for the bigger loan (the bank will check your income can support the higher amount, just like any new loan application). Lenders will often ask your purpose for the funds and some have limits on cash-out for unspecified purposes.
E.g. Large amounts might need to be used solely for investment or renovation, etc. due to responsible lending rules.
Pros & Cons
Benefits:
- Access to more favourable loan terms & interest rates than your current loan
- Can fund home improvements at lower interest rates than personal loans
- Debt consolidation by paying off higher-interest debt like credit cards or student loans (keep in mind the interest will not be deductible as these are not investment purposes)
- Provide extra cash for investing in property or other assets, ultimately accelerating wealth creation Considerations:
- Cost considerations (same as those listed in the Refinance section).
- Budgeting to ensure you can service the additional repayments (including scenarios where variable interest rates increase) to avoid defaulting and risking foreclosure
- Loan Tenor of the loan may be extended if you refinance your entire home loan
Considerations:
- Cost considerations (same as those listed in the Refinance section).
- Budgeting to ensure you can service the additional repayments (including scenarios where variable interest rates increase) to avoid defaulting and risking foreclosure
- Loan Tenor of the loan may be extended if you refinance your entire home loan
Each method has its own advantages and may suit different financial situations. It’s important to compare these options based on interest rates, fees, repayment terms, and how they affect your overall financial plan. Consulting with a mortgage broker or financial advisor can help you decide which option is best for you.
Tax Implications: Deductible Interest
A critical factor with equity loans is what you use the money for, especially if you have an investment property or plan to claim interest as a tax deduction.
The Australian Taxation Office (ATO) confirms that interest on funds withdrawn to purchase a new income-producing asset (like a rental property) is deductible under section 8-1 of the Income Tax Assessment Act 1997.
If you redraw or refinance and use part of the loan for a private purpose, the interest on that portion is not tax-deductible. It doesn’t matter that the loan is secured by an investment property or that it came from the same loan – what matters is the purpose of the funds.
For example, say your original loan is for an rental investment property (so interest is tax-deductible as it’s funding an income-producing asset). If you then refinance and pull equity to buy a new personal car, the interest on that car portion of the loan cannot be claimed on his rental property tax return. The loan has become a mixed-purpose loan.
The ATO requires a reasonable apportionment of interest between deductible (investment) and non-deductible (private) portions. Typically, you’d apportion it by the loan amounts and deduct the portion that was used to fund investments.
The ATO’s ruling on interest expense deductions is summarised as:
- Interest on loans used for private = 0%
- Interest on loans used for investments = 100%
- Interest on mixed use loans = Investment-related interest / Total interest = [x]% deductible
This is why some people split their loans when drawing equity – e.g. one split for the investment portion, one for personal – to keep the interest separate for accounting. It’s highly recommended to get tax advice when doing a cash-out refinance for investment purposes, to ensure you structure it right and stay within ATO rules.
Example: Cash-out Refinance
Consider an owner’s Main Residence is valued at $1,000,000 with an existing mortgage of $500,000.
With an 80% LVR, the maximum allowable loan is 80% of $1,000,000, which equals $800,000.
‘Cash-out’ refinancing to $800,000 results in a cash-out amount of $300,000 (i.e. $800,000 – $500,000).
The $300,000 is used to purchase an investment property.
Key Points:
The interest on the $300,000 used for the investment is tax-deductible since it’s allocated for income-producing purposes.
Out of the total refinanced loan of $800,000, 37.5% (i.e. $300,000 divided by $800,000) is deductible.
The remaining $500,000 continues to finance the PPOR, and the interest on that portion is not deductible.
Construction loans
Construction loans are specialised home loans designed for building a new property or making major renovations where the full amount is not needed all at once and the property (collateral) is not yet complete.
They are characterised by 2 key phases;
1. Drawdown Phase
2. Repayment Phase
Determining how much you can borrow
Valuation-Based Method: based on the property’s projected value on-completion (ARV).
Max. Construction Debt = Valuepost x LVR%
Total Debt at Completion = Current Debt + Max. Construction Debt
Deposit Required = MAX(Total Debt at Completion – Max. Construction Debt, 0)
Drawdown Amount = Construction Cost – Deposit Required
Example
If the expected post-renovation value is $600,000 with an 80% LVR, then the total loan allowed is $480,000. If your existing mortgage is $400,000 then:
Additional Loan = $480,000 - $400,000 = $80,000
If your renovation costs are $100,000 you’ll need to cover an extra $20,000 in cash.
Cost-Based Method: based on the total estimated construction cost of the project.
Valuepost = Valuepre + Construction Cost
Max. Construction Debt = Valuepost x LVR%
Additional Construction Debt = Max. Construction Debt – Current Debt
Deposit Required = MAX(Construction Cost – Construction Debt, 0)
Example
Suppose your property’s current value is $500,000 the renovation cost is $80,000 and you have an existing mortgage of $400,000 with an 80% LVR:
Vtotal = $500,000 + $80,000 = $580,000
Total Loanmax = $580,000 * 0.80 = $464,000
Additional Loan = $464,000 - $400,000 = $64,000
If your renovation costs are $80,000 you’ll need to cover:
Cash Required = $80,000 - $64,000 = $16,000
Both methods involve a detailed appraisal, including a builder’s quote and market analysis. Further, your credit history, deposit, and projected expenses all factor into how much you can borrow.
Just like regular home loans, construction loans require a deposit, and LMI is still generally applied to loans exceeding an 80% LVR.
The Drawdown Phase
Construction loan funding is dispersed under what’s known as a ‘progressive drawdown’ system, whereby a specific % of the funds are released as the construction reaches a series of milestones:
1. Deposit to builder: Often 5–10% of the contract price is paid upfront from your funds (this is usually your deposit portion as equity is used first).
2. Base/Slab stage: The foundations are laid (concrete slab or footings) – roughly 10–15% of the contract is due.
3. Frame stage: Frame and roof structure built – say 15–20% due.
4. Lockup (Enclosed) stage: External walls, windows and doors in place – another ~20% due.
5. Fit-out/Fixing stage: Interiors are fitted (plaster, cabinets, fixtures, plumbing, electrical) – the largest chunk, often 20–30%, is due at this stage.
6. Completion stage: Final finishes, painting, and handover – remaining balance (often 10% or so) is due.
During the construction phase, virtually all construction loans are set up as interest-only. This means you only pay interest on the amount that has been drawn so far, not on the total approved loan.
Due to the progressive nature of the drawdown phase (i.e. your loan balance increasing at each stage), your monthly interest payments increase gradually throughout the project, and unlike most standard construction loans, it is not added to the loan balance – you are required to pay it each month.
The Repayment Phase
Once your home is completed and the final payment to the builder has been made, your construction loan will convert to a regular home loan.
There isn’t usually a need to refinance or sign a new loan contract with the same lender – it typically rolls over automatically into the “repayment” phase as outlined in your loan agreement.
1. The bank will ask for any final documents (like the occupancy certificate and proof of building insurance)
2. A final valuation/inspection will be conducted confirming the property is complete and corresponds to what was intended – this protects both you and the lender, ensuring you have a fully built home.
3. Your loan repayments will usually switch to principal and interest (P&I), and your monthly repayments will now start paying down the principal in addition to the interest. Because of this, your required payment will increase compared to the interest-only payments during the build (unless you negotiate an interest-only period).
4. From here on, the loan functions just like any other home mortgage, and any unused funds from the construction facility are cancelled.
Refinancing Considerations
After your home is built, you might consider refinancing the loan with a different lender, or moving to a different loan product with the same lender, to get a better interest rate or features. During the construction period, you might have been on a special construction variable rate.
Additionally, if your completed home is now worth substantially more than what it cost, your LVR might have dropped, which could let you refinance without LMI or get a better rate.
Example: Drawdown to Repayment Phase
Consider a $1,000,000 Construction Loan.
Drawdown Phase:
Deposit to Builder: 10% → $100,000
Base/Slab Stage: 15% → $150,000 (Cumulative: $250,000)
Frame Stage: 20% → $200,000 (Cumulative: $450,000)
Lockup Stage: 20% → $200,000 (Cumulative: $650,000)
Fit-out Stage: 25% → $250,000 (Cumulative: $900,000)
Completion Stage: 10% → $100,000 (Total Drawdown: $1,000,000)
Interest During Drawdown (Assuming 5% p.a. calculated monthly):
After Deposit: ~$416/month on $100,000
After Base/Slab: ~$1,041/month on $250,000
After Frame: ~$1,875/month on $450,000
After Lockup: ~$2,708/month on $650,000
After Fit-out: ~$3,750/month on $900,000
After Completion: ~$4,166/month on $1,000,000
Repayment Phase (Conversion):
Loan Amount: $1,000,000
Converted to a Principal & Interest loan (e.g., 25-year term at 5% p.a.)
Estimated Monthly Repayment: ~$5,845 per month
Key Considerations
- Cost overruns: Lenders will not automatically increase your loan if you go over the contracted amount. You would typically need to cover any extra costs yourself or approach the bank for a variation/new approval (which can be difficult and time-consuming). This is why having a contingency fund (e.g. 10-15% of the contract price) in reserve is so important.
- Delays & timing: Most construction loans come with a time limit. Commonly, lenders expect construction to commence within 12 months of loan approval and be completed within 12 to 24 months of the first drawdown. Delays may mean paying interest for longer, incurring additional holding costs from contractors and even requiring a revised valuation.
- Build or contractor issues: Any change in the scope of works or construction contract might trigger a new valuation before the bank agrees to continue funding.
- Fees: Many lenders will charge a ‘progress payment fee’ (~$250) for each drawdown made, or a one-time fee covering the full amount (~$750).
- Insurance Requirements: During construction, the builder is usually required to have insurance that covers the project (public liability, construction risk, and in residential cases Home Warranty Insurance which protects you if the builder cannot complete the work). The lender will want evidence of these before first drawdown and, once the build is nearing completion, you need to arrange home building insurance on the new property which typically, you’d start the policy from the day you get the keys or the day of handover.
Government incentives
- First Home Owner Grant (FHOG): a one-off grant which varies by state (often around $10,000 to $15,000) for eligible first-time buyers who build a new home.
- First Home Guarantee: (formerly First Home Loan Deposit Scheme): a scheme allowing first-home buyers to purchase or build with as little as 5% deposit, without paying LMI, because the government acts as guarantor for the loan.
This content is based on information obtained from sources believed to be reliable and accurate at the time of publication, but we do not make any representation or warranty that it is accurate, complete or up to date. We accept no ongoing obligation to correct or update the information or opinions in it. Opinions expressed are subject to change without notice, and do not constitute financial product advice.
We do not provide tax agent services. The information provided in this article should not be relied upon to satisfy liabilities or obligations that arise, or could arise, under a taxation law or to claim entitlements that arise, or could arise, under a taxation law. You should seek professional tax advice to understand your tax liabilities, obligations and entitlements.
