Mortgage basics: how a home loan works

A home loan, or mortgage, is money a lender gives you to buy a property. In return, the property is used as security. If the loan isn’t repaid as agreed, the lender can sell the property to recover what it’s owed. Day to day, it’s simply a long-term arrangement where you make regular repayments until the debt is cleared.

Knowing a handful of key terms makes the whole process far less daunting.

The building blocks: principal, interest and term

• Principal is the amount you borrow. If you buy a home for $700,000 and borrow $560,000, your principal is $560,000.
• Interest is what the lender charges you for borrowing. It’s usually calculated daily on the balance you owe and charged monthly. As the balance falls, so does the interest.
• Loan term is how long you have to repay the loan, commonly up to 30 years. A shorter term means higher repayments but less interest overall. A longer term lowers each repayment but usually costs more in total.

Principal and interest vs interest-only

Most people buying a home to live in choose principal and interest (P&I) repayments. Each repayment covers that month’s interest plus a portion of the principal, so the debt shrinks over time. In the early years, most of each repayment goes to interest. Later on, more of it goes to the principal.

With interest-only repayments, you pay just the interest for a set period, often up to five years. Your repayments are lower during that time, but the amount you owe doesn’t go down. When the interest-only period ends, the loan switches to P&I and repayments rise, sometimes sharply, because you now have fewer years left to repay the full balance. Interest-only loans can also carry a higher interest rate, so they tend to suit particular situations rather than being a default choice.

Fixed, variable or a bit of both

Your interest rate can be variable, meaning it can move up or down over time. It can be fixed, meaning it stays the same for a set period, usually one to five years. Or it can be split, with part of the loan fixed and part variable. Each option trades off certainty against flexibility, so the right mix depends on your plans and how much you value predictable repayments.

Deposit and LVR

Your deposit is the part of the purchase price you pay from your own savings or equity. Lenders compare the size of your loan to the property’s value using the loan-to-value ratio (LVR). Borrow $560,000 against a $700,000 home and your LVR is 80%. These figures are illustrative only.

LVR matters because it affects which loans are open to you, how the lender prices your loan and whether you’ll pay lenders mortgage insurance (LMI). LMI usually applies when you borrow more than 80% of the property’s value. A deposit of 20% is a common savings goal for this reason, although some buyers purchase with less, for example with a family guarantor or through a government scheme.

The deposit isn’t the only money you’ll need. Stamp duty, conveyancing, building and pest inspections and loan costs all come on top, so it pays to budget for them early.

Fees to look out for

Interest isn’t the only cost of a home loan. Common fees include:

• Application or establishment fees when the loan is set up.
• Valuation fees, if the lender charges for valuing the property.
• Ongoing fees, such as monthly account fees or an annual package fee.
• Government fees to register the mortgage and transfer the title.
• Discharge fees when you pay off or refinance the loan.
• Break costs, which can apply if you leave a fixed rate early.

The comparison rate combines the interest rate and most fees into a single figure, which helps when lining loans up side by side. It’s a useful guide, though it won’t capture every cost or feature. Each lender also provides a Key Fact Sheet that sets out the loan’s details in a standard format.

A note from Jenny The repayment figure is only part of the picture. When I compare loans for clients, I look at the fees, the features they’ll actually use and how the loan fits their plans over the next few years, not just the headline rate.

From first conversation to settlement

Every purchase is a little different, but most follow a similar path:

1. First conversation. You talk through your goals, income, expenses, savings and timing with your lending specialist.
2. Documents and pre-approval. You provide ID, income evidence and bank statements. Your lending specialist compares lenders and applies for pre-approval, which gives you a realistic budget to shop with.
3. Finding a property. You search, inspect and arrange checks such as a building and pest inspection. A conveyancer or solicitor reviews the contract before you sign.
4. Signing the contract. Once you buy at auction or have an offer accepted, you sign the contract and pay the deposit it requires.
5. Formal approval. The lender values the property and confirms your details. If everything checks out, you receive formal approval.
6. Loan documents. You review and sign the loan contract and mortgage documents. Read them carefully and ask about anything that isn’t clear.
7. Settlement. On settlement day, the lender pays the seller, the title moves into your name and you collect the keys. Your first repayment is usually due about a month later.

After settlement, it’s worth reviewing your loan regularly. Your circumstances and the market will change over the years, and a loan that suited you at the start may not suit you forever.

This information is general in nature and does not take into account your objectives, financial situation or needs. Lending criteria, terms, fees and charges apply and vary between lenders. Speak with us for advice about your circumstances.