There is jargon in most industries and the property finance sector is no exception. In fact, property finance is rife with jargon and terminology that can confuse even seasoned buyers and sellers.
Here are 5 of the most commonly used but misunderstood property finance terms.
When the RBA releases its cash rate decision on the first Tuesday of every month, do you read the news but wonder what the cash rate actually is and why it is different to the interest rate applied to your mortgage?
The cash rate currently stands at the historically low 0.1%, however mortgage rates are typically a few percentage points higher. That’s because the cash rate serves as a benchmark from which interest rates for both home loans and savings accounts are based. In simple terms, the cash rate is the interest rate at which banks borrow or lend money to each other. Lowering the cash rate is done to encourage economic activity and borrowing, while raising the cash rate helps moderate economic growth and control inflation.
Loan to value ratio
Expressed as a percentage, the loan to value ratio (LVR) reflects the size of a loan in relation to the value of the property. The percentage is calculated by dividing the loan amount by the property value. The lower the LVR, the less risk the loan presents to the bank. That’s because if the owner defaults and the bank is forced to sell, there is less chance that the property value will be less than the sale price (given markets go up and down) making it easier for the bank to recoup their funds. It is for this reason that most lenders require an LVR of 80% or less or lenders mortgage insurance may be required. That brings us to our next term…
Lenders Mortgage Insurance
Lenders Mortgage Insurance (LMI) is typically a one-off payment made at settlement by the borrower. It is commonly required when buying a property with a loan to value ratio (LVR) of more than 80%. The insurance protects the lender in case the borrower defaults on the loan and there is a shortfall after the sale of the property. Let’s look at an example. If you are buying a home for $750,000 with an LVR of 85%, your LMI would be around $8,000. If the LVR is 95%, the LMI could cost as much as $30,000. These days, many first homebuyers are opting to pay LMI in order to get into the market sooner and finding the cost to be worth it for that benefit, especially as rents increase.
Home loan pre-approval
Also known as ‘conditional approval’, home loan pre-approval provides a homebuyer with an indication of how much money they may be able to borrow from a specific lender. In this way, it offers a spending limit and the confidence to submit offers within that limit. It is conditional because it is subject to various conditions, including a valuation of the property being purchased and additional verification of the borrower’s financial situation. Usually, home loan pre-approval has a limit of 90 days, which can be extended as long as updated information is provided.
An offset account is a bank account that is linked to the home loan and is used to help reduce the interest payable on the loan. The non-interest-bearing account operates like a standard transaction account, giving borrowers complete control over their money.
When the bank determines the interest to be charged, any funds in the offset account are deducted from the loan balance. For instance, if you have a $400,000 loan and $20,000 in your offset account, you will pay interest on $380,000 rather than $400,000. By reducing the interest payable, household cash flow increases, which in turn allows savings in the offset account to accumulate more rapidly. It offers the same benefit as making extra repayments but with added flexibility and no fees or redraw limits.