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Cheap loans - what's the catch?.

You want to pay off your home loan as quickly as possible. You took the time to find the lowest rate available, yet a couple of years down the track, you're paying a lot more than you bargained for. What went wrong? Mortgage One have examined the cheap home loans and discover why, sometimes, interest rates don't tell the whole story.

Determining whether to opt for a 'no frills' loan with a lower interest rate or one of the latest feature-packed loans that promises to reduce the term of a loan and save you thousands of dollars in the process can be a daunting task, but Mortgage One have broken it down into two steps: finding the right type of loan, and finding the cheapest loan of that type.

Which loan is the right loan?

Home loans come in a variety of shapes and sizes. There are basic ‘no frills’ home loans, introductory loans, standard variable loans, fully-featured loans as well as all-in-one accounts, revolving lines of credit, home loans with a salary account, 100 per cent offset accounts and partial offset accounts - not to mention a variety of fixed rate loans covering different lengths of time.

If every home loans had identical features, then you could safely compare loans adopting the 'cheapest is best' policy. However, the features and flexibility offered with home loans today make such a simple comparison unrealistic.

Basic 'No Frills' Loans

Cheap home loans typically offer lower interest rates than their feature-packed cousins. The result is lower minimum monthly repayments for the borrower. However, the borrower will be able to make additional repayments, redraw these additional payments at a later date for a fee and lose the ability to credit their salary directly into their loan account.

Cheap loans with minimum features may be useful for people who know that they will never need additional flexibility with their loan, haven't the means to pay more than their minimum repayments or have accepted the fact that they are in for a 25 (or even 30)

year haul before they can call their home their own. A generation ago, this description probably suited many home loan borrowers, but the story has changed today. The lack of flexibility is a definite turn-off for many people contemplating cheap loans with minimum features.

Introductory loans

Introductory loans can also disadvantage borrowers. An attractive rate is advertised, and will apply to your loan for the first 6 months or 12 months. Doing your sums you determine that the minimum monthly repayments will be easy to meet and you quickly sign and cruise through the 'honeymoon' period.

However, all honeymoons come to an end, and the minimum monthly repayment you had been enjoying very quickly turns into a standard variable rate - or in some cases something even higher. Unless your income has risen over the honeymoon period, you could be required to do some serious belt-tightening. However, if you determine a particular honeymoon loan is competitive, we recommend you 'skip the honeymoon' and make full repayments from day one of your loan.

All-in-one loans

An all-in-one loan is effectively the combination of all your savings and cheque accounts into one loan account. All-in-one loans allow you to have all your earnings placed directly into your loan account. Amounts above the minimum repayment can then be accessed from the loan account just like a day-to-day transaction account. This means that the money which would normally be sitting in your daily transaction account earning precious little (if any) interest can be saving you money on your home loan instead.

It's a very simple system. Because interest is calculated daily but only charged monthly, every dollar left in your loan account reduces the amount on which interest is calculated. The more money left in your account for a longer period of time, the faster you will pay off your home loan. This is similar, but not quite the same as loans with an offset account.

100% offset loans

A 100% offset account is similar in principle to an all-in-one account. Rather than having all your money consolidated into one home loan account, a 100% offset account is a separate account run in conjunction with your home loan account. It operates like a savings or transaction account with an interest rate equal to that charged on your loan account.

If, for example, your home loan has a current balance of $310,000, where interest would be calculated on a daily basis and charged to the account each month on that full amount. However you have a 100% offset account, where you place all your earnings and savings, and the balance for example is $25,000, that money acts to reduce the balance on your home loan.

Rather than earn interest on the $25,000 at the current term deposit rate, usually 2% or lower, your savings, in the 100 per cent offset account, effectively reduces the balance of your loan, so you only pay interest on the difference being $295,000.

Redraw facilities

A redraw facility operates in a similar fashion to an all-in-one and 100% offset accounts but is less flexible. With an offset account there exists a separate account where you make your deposits, but with a redraw facility you make your deposits directly into the loan account. The redraw facility allows you to access any additional repayments that you have paid into the loan account.

In a similar fashion to an all-in-one loan, home loans that have a redraw facility allow borrowers to withdraw additional repayments, which have been made, subject to certain terms and conditions. These terms and conditions vary significantly between lenders.

A redraw facility can be a valuable feature because it allows you to make additional repayments (reducing the total interest you pay on the loan) with the knowledge that you can access the money at a later date, should you need to.

I'll take the cheap loan thanks

Once you determine the type of loan you want, the next step of comparing loan rates should simply be a case of determining the cheapest loan of the type that you require. Unfortunately, this isn't always a simple thing to do. Lender have varied and sometimes complicated pricing structures including establishment fees, valuation fees, legal fees, settlement fees, package fees, monthly fees, transaction fee.........and more fees.

A level playing field?

Comparison rates are supposed to provide borrowers with a 'level playing field' when it comes to determining the cheapest loan available. However, the cheapest loan is not always the best one for your circumstances. As you'll discover, comparison rates are certainly useful, but you need to understand what they do, and more importantly what they don't, when looking for the best possible loan available. Over the life of a typical loan, making the right decision can save you thousands of dollars.

Comparison rates incorporate the fees associated with a loan into the interest rate to give you a better indication of the 'true' cost of the loan. They do this by incorporating all the set up fees you have to pay the lender to enter the loan, plus any ongoing fees which must be paid with the quoted interest rate. This produces a comparison rate you can use to compare loans, knowing that fees are included in the comparison rate.

However, focusing on the comparison rate alone can be misleading as repayment flexibility and other loan features are not incorporated in comparison rates and the assumptions adopted in the calculation can also have a significant impact. This makes using comparison rates confusing.