Loan facilities, features and risks
Interest is the cost of debt, or the price you pay for the privilege of receiving a loan from a someone. Interest acts as compensation for the provider being unable to use the money for alternative investments.
If you are considered a low risk borrower, the provider will charge you a lower interest rate than someone considered high risk.
Fixed Rate Loan
A fixed rate loan protects you against the risk of an interest rate rise by fixing the interest rate applicable to all or a portion of, you loan for a set time period.
If interest rates rise you will the security of knowing the interest rate on the fixed portion of your loan and your regular repayments will not change until the end of the fixed period.
You should be aware that:
Fixed rate loans are often higher than variable rate loans.
If variable interest rates fall during the term of your fixed interest rate loan, you won’t benefit from this.
Fixed rate loans generally have limited features and restrictions are applied on additional repayments which may prevent you from accelerating the repayment of your loan.
Early payout fees usually apply to fixed rate loans.
Variable Rate Loan
A variable rate loan involves a fluctuating interest rate which changes relative the market interest rates at large, meaning that your repayments may ‘vary’.
Variable rate loans often have a lower interest rate than fixed rate loans, as well as offering a greater suite of features, such as:
The ability to make extra payments
The use of redraw facilities and offset accounts
Ease of switching loans in order to make a better deal
The drawbacks associated with a Variable Rate Loan include:
- Increased difficulty budgeting your loan repayments
- Mortgage stress associated with not being able to make your loan repayments due to interest rate increases
Offset Accounts and Redraw Facilities
Offset Accounts and Redraw Facilities are home loan features which can assist in reducing your interest repayments over the long term by using extra income or savings to reduce the balance of your loan.
The two features are similar; however, they operate differently.
An offset account involves considering the money held in the account and ‘offsetting’ the amount against the balance of your loan, reducing your interest liability.
This type of account is not unlike your regular transaction account used for every-day purchases, as it offers complete flexibility and access to your funds.
An important consideration for the use of an offset account is that they may incur a fee and/or higher interest rates.
A Redraw facility involves depositing any spare income towards your home loan (above your minimum repayment requirement), with the benefit of reducing the interest being charged and term of the loan.
Any additional funds put towards the loan will be available to be withdrawn upon an application to your lender.
Important considerations for the use of a redraw facility include the possibility of fees payable and restrictions on withdrawal amounts.
Debt can be divided into two categories, efficient and inefficient debt.
Debt is efficient when it is taken out for the purpose of purchasing income producing assets, such as a share portfolio or investment property. Debt which has been taken out for the purchase of services or assets which won’t generate an income are considered inefficient.
Efficient debt is considered preferable to hold due to the characteristics of interest being a tax deductable expense, thus reducing your income tax liability. Inefficient debt has no such tax benefits.
If your inefficient debt is not managed properly, your long-term wealth creation potential may be impacted.
Benefits of accelerating the reduction of inefficient debt
- Reducing the total amount of your interest payments
- Increase the equity in your home, which can be used to then take out an investment loan
Strategies to reduce inefficient debt
Australian Wealth Solutions utilises various debt management strategies to reduce our clients’ inefficient debt, including:
- Increasing regular payments
- Increasing the frequency of regular payments
- Making lump sum payments
- Utilising credit card facilities
- Debt consolidation
- Debt recycling