22 Sep 2021

Five common yet confusing property finance terms explained

Property finance is riddled with terminology and jargon that can confuse even experienced buyers and sellers, let alone first-timers.

Arming yourself with knowledge before making a move improves your chances of success in the long run.

Cash rate

The cash rate serves as a benchmark from which interest rates for home loans and savings accounts are based. It’s the rate used for unsecured overnight loans between banks or, in other words, the interest rate at which banks borrow or lend money to each other.

Each month, the Reserve Bank of Australia board meets and sets a cash rate target. Lowering the cash rate makes home loans cheaper, and is done to encourage borrowing and economic activity. Raising the cash rate increases the cost of borrowing and helps moderate economic growth, and is usually done to control inflation.

The cash rate is currently sitting at a record low of 0.10 per cent, but mortgage rates are typically a few percentage points higher, reflecting banks’ profit margins.

In most cases, when the cash rate goes up or down, the rate borrowers pay on variable loans also changes, although not always by the corresponding amount. 

Loan-to-value ratio 

This ratio reflects the size of the loan in proportion to the value of the property. It’s expressed as a percentage, calculated by dividing the amount borrowed by the value of the property.

A lower loan-to-value ratio (LVR), such as 60 or 70 per cent, will usually make a mortgage less risky for a bank. If the owner defaults and the bank forces a sale, there is a lower chance that the property’s value will be less than the loan.

When a property is purchased with a higher LVR, such as above 80 per cent, it’s often a condition of the loan that the borrower buys lenders mortgage insurance.

Lenders mortgage insurance 

Commonly abbreviated to LMI, lenders mortgage insurance protects the lender from a financial loss if the borrower defaults on a home loan and there is a shortfall in value after the sale of the property. 

LMI is usually a one-off payment made by the borrower at settlement, and is required when buying with a loan-to-value ratio above 80 per cent.

For a $750,000 property with an LVR of 85 per cent, borrowers should expect LMI to cost about $8000. If the LVR is 95 per cent, the cost could be about $30,000.

Some borrowers with smaller deposits choose to pay LMI to get into the property market sooner. Other buyers with smaller deposits may have a parent act as guarantor to avoid paying LMI at all, and it may be waived for borrowers in certain high-income professions.

Home loan pre-approval 

Home loan pre-approval, also known as conditional approval, provides a borrower with a non-binding indication of the amount of money a specific lender may lend, after reviewing their financial situation. It is subject to several conditions, including a valuation of the property and further verification of the borrower’s financial information.

Pre-approval gives buyers a spending limit, as well as the confidence to pursue properties within a set price bracket and submit offers. It’s typically valid for 90 days and can be extended with updated information.

Buyers should arrange pre-approval as soon as they’re serious about buying a property, and definitely before bidding at auction, as auction sales are unconditional and cannot be subject to additional finance approval.

Offset account 

An offset account is a bank account linked to a home loan that can reduce the interest payable on the loan. 

When determining the interest to be charged on the loan, any money in the offset account is deducted from the loan balance. For example, a borrower with a $500,000 loan and $50,000 in their offset account will only pay interest on $450,000. However, no interest is earned on money in an offset account.

Keeping money in an offset account reduces a borrower’s interest payments, which increases household cash flow and allows savings in the offset account to accumulate faster. This creates a “feedback loop” which further increases the rate borrowers can save.

Offset accounts operate like standard transaction accounts, giving borrowers control over their money. Keeping money in an offset account has the same effect of making extra repayments, but with added flexibility and no redraw limits or fees.

See the Domain Dictionary for more property and finance definitions.

SOURCE: https://www.domain.com.au/money-markets/confusing-property-terminology-explained-1044512/

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