Episode 21 | Unlocking How Your Mortgage Actually Works

We're kicking off our Finance 101 series by unpacking what a mortgage really is, not just the numbers and the jargon, but the strategy behind it. Because when you actually understand how your mortgage works, every decision you make from how often you repay to how you structure your loan can help you pay it off faster and build long-term flexibility. Hello and welcome to First Home Unlocked, the podcast for unlocking clarity and confidence for first home bias. I'm Jack Elliott, national first home bias specialist at Alcove. And I'm Chris Brates, ex financial planner and mortgage broker. Together we are on a mission to empower you with the keys to unlock your first home. Let's jump in. Hello and welcome back to First Home Unlocked, for today's episode we're going right back to basics. So in this episode what we'll cover is what a mortgage really is and how it actually works behind the scenes, the key moving parts, principal interests, repayments and loan term and how to think strategically at every stage so your mortgage works for you. Let's jump in. All right, let's talk about what a mortgage actually is. It sounds simple but we want to help you understand what's happening behind the scenes and the different levers that you can pull. A mortgage is essentially a loan that helps you buy a property and that property becomes the security for that loan. So the bank lends you the upfront money, you agree to pay it back plus interest over time and if you can't make those repayments, the bank has the right to take possession of the property because it's their security. Most home lines in Australia run for about 30 years and come with different options like fixed or variable interest rates and a range of fees or features. Now let's break down the main parts of a mortgage. First you have your principal, this is the amount you actually borrow from the bank, then you have your interest which is the cost of borrowing that money. It's what you pay back to the bank on top of the principal for the ability to use their funds now. You then have the interest rate which is the percentage the bank charges on that line. This can be fixed or variable and will change over time. You have your repayments and these are made up of both principal and interest and you can usually choose to pay them either weekly, fortnightly or monthly and then you have your loan term which is the length of time you have to repay the loan usually up to 30 years. Now I know this might sound simple but for most people this isn't actually something that gets taught. So we're going to go through each component one by one and if you're going to take on hundreds of thousands of dollars of debt you want to understand what's going on and how it all works. Alright so let's talk about interest and how it's actually calculated even though you might make your repayments weekly, fortnightly or monthly interest is calculated daily on your loan balance. So every day that your loan sits there you're being charged interest on whatever amount you still owe and because it's charged daily the sooner you reduce that balance even by small amounts the less total interest you'll pay over time. Now one of the things that surprises most first home buyers is how much they'll end up repaying in total over the life of a loan. When you look at a 30 year loan the total amount repaid is usually much higher than what you originally borrowed and that's because of how interest compounds. So let's put that into perspective with a quick example. Let's say you're buying a property for $800,000 in new South Wales using the first home guarantee scheme to cover the 5% loan deposit you'll need $40,000 so your loan amount required is $760,000. You need to cover the other upfront cost out of pocket with your own savings things like stamp duty, convincing and moving costs. If you want the full breakdown of those jump back to episode three I'm looking the real cost of buying your first time. So if you're starting interest rate was 5.45% and you're making fortnightly repayments over a 30 year loan term and let's just say for the sake of this example assume rates never changed you would repay around $1.5 million in total even though you originally only borrowed $760,000 you would also be paying back approximately $780,000 in interest. That means you're paying about double what you actually borrowed and that's the impact of compound interest over time. Now I know this could be really confronting but it's all about understanding the full picture so you can take strategic action. We'll talk about how to reduce the amount of interest you pay using tools like offset, redraw and extra repayments in future episodes. So now that we understand how interest works day to day let's talk about interest rates because this is one of the biggest factors that determines how much you'll actually repay. It's also the part that gets the most attention in the media. Every time the reserve bank moves the cash rate you'll see headlines about how it's going to affect more good shoulders but here's the reality your interest rate will move over time. The rate you start with is not the rate that you will stay with so it's important to understand this upfront. The interest rate is simply the percentage the bank charges you on the money you have borrowed. It can be fixed for a period or variable and it will go up and down depending on the market. Now a variable interest rate means that your rate can move up or down depending on the lending market mainly influenced by the changes to the reserve bank's cash rate but also things like the bank's own funding costs, competition and lending conditions. It's the most common type of loan for first home buyers because it gives you flexibility. So advantages of a variable rate are you can usually make extra repayments whenever you like without penalty. Many variable loans offer features like offset accounts or redraw which can help you reduce how much interest you pay while still giving you access to your money. If rates fall your repayment doesn't automatically change but more of what your paying goes towards reducing your actual loan balance rather than interest. You can also ask your bank to lower your minimum repayment in line with the rate drop which can help free up some extra cash flow if you need it. And finally it's usually easy to refinance if you find a better deal later on because there is no fixed term break costs. Now the disadvantages of a variable rate are rates rise your repayments will increase and that can put pressure on your budget. It also can be harder to plan long term because repayments fluctuate over time. So you'll need to be comfortable with some uncertainty and have buffers in place to handle rate rises. So if you like flexibility and can handle some movement in your repayments, variable loans work really well. Especially when paired with an offset account or a strong savings plan. Now a fixed interest rate means your rate stays the same for a set period usually between one and five years. You'll know exactly what your repayments will be during that time which can give you certainty and peace of mind. Advantages of a fixed rate are it makes budgeting easier because your repayments will stay the same. It protects you from rate rises during the fixed period and provides you a sense of stability. The disadvantages of fixed rates are you generally can't make large extra repayments although be kept at a small annual limit. If you want to refinance sale or repay early you could face significant break costs. Most fixed loans don't include offset accounts or redraw so you lose some flexibility and if rates fall you won't benefit and you may be locked into paying a higher rate for the remainder of your fixed interest period. So fixed rates can be great if you value your predictability and you're worried about rate rises but that certainty comes at a cost of flexibility and you won't be able to utilize strategies to reduce the interest you pay over time like your offset account, redraw or extra repayments. Your broker can help you work out what's best for your situation with your goals and the current rate environment in mind. So again I just want to make it clear that rates will change over time. Most lenders assess your application using a 3% assessment buffer which means they test whether you could still afford the repayments if rates increased by 3%. It's designed as a safety net but it's still really important to think about your own comfort level and your budget. Just because the banks say yes doesn't mean that it would be comfortable or realistic for you. If rates did rise how would that impact your cash flow, your lifestyle and your savings. Building that awareness early helps you set up alone with confidence. We'll go deeper in a future episode into how interest rate are actually set and why they move but for now the key takeaway is this. Rates will always change. So understanding your budget knowing what feels comfortable and keeping strong buffers in place like an emergency fund will give you the confidence no matter where rates go. All right so let's talk about repayments. Those repayments are made up of two parts, principal and interest. Like we mentioned earlier the principal is the amount you've actually borrowed and the interest is the extra you're paying the bank for the ability to use their money. And especially early on most of your repayment is actually going towards interest not your loan balance. This is because interest is calculated on what you still owe and at the beginning that balance is at its highest. So even though you're making consistent repayments it may take a while before you feel like you're really chipping away at the debt. Let's use an example to make this clear. Using that same example from before with a $760,000 loan at a 4.45% interest rate over 30 years your fortnightly repayments would be $1,980. Initially about $1,590 of each repayment goes towards interest and only $389 to the loan balance. By around year 18 of holding that loan more of your repayment starts going towards paying down the principal rather than the interest. Now this is where understanding your structure matters because once you know what's happening behind the scenes you can make small, smart changes that save you big money over time. You can also use this information strategically. If you refinance in the future by keeping your loan term the same rather than resetting it to a new 30 year loan term if you can. This saves you a lot on interest in the long run. Now let's talk about loan terms. Your loan term is simply the length of time you agree to take to repay your loan in full. The most common loan term offered by lenders is 30 years but you can also choose shorter options like 15, 20 or 25 years and we're now starting to see some lenders even offering 35 or 40 year loan terms. Most of our clients choose a 30 year term and that's not always because they plan to take 30 years to pay off their loan. It's because it gives them flexibility. A longer term keeps your minimum repayments lower which helps you manage cash flow more comfortably and you can pay extra when your situation allows. If you're in a strong financial position right now you can always make extra repayments using your offset or redraw to reduce the interest and pay the loan off faster. But if life changes maybe you start a family take time off work or shift to a single income you've got the flexibility to pull back to the minimum repayments and if you build up extra repayments a longer way using your offset or redraw that money is still accessible giving you an added layer of security. It's really about building a loan structure that supports you through different seasons of life and not just the one you're in today. So the key takeaway to remember is a longer term equals lower repayments and more flexibility but more total interest paid. Starting with a 30 year term gives you options. You can pay more when your situation allows but you can pull back if things tighten and if you want to get ahead extra repayments using your offset and your redraw are far more flexible tools and locking yourself into a shorter term. Now before we wrap up I want to quickly touch on your loan fees and features. Most lines come with some upfront costs like an application or settlement fee and many lenders charge a small annual or monthly fee if your loan includes an offset account. But the benefit of an offset account far outweighs the fee especially when you use it strategically to reduce the interest you're paying and shorten your loan term. So when you understand how your mortgage works you can make clearer, calmer decisions and manage your loan with confidence and if you're taking on a mortgage it's a really big deal. It's probably one of the biggest financial commitments you'll ever make and even though we're spent this episode understanding the mortgage itself the most important thing really does come back to choosing the right property. One that is a high quality asset that suits your goals. That's where understanding your goals and vision like we covered back an episode one is so important and it helps you choose a property that supports your life over the next five to ten years. And if you haven't yet go back and listen to episode six unlocking asset quality where we talk about how to find a property that's more likely to grow in value over time. And if you're ready to unlock your first home you can book in a get to know you chat with me at firsttime unlock.com.au/book or by using the link in the show notes. Next week we'll continue our finance 101 series. Thanks for tuning in and I'll see you next week. Thank you so much for listening. We'd really appreciate it if you could do us a huge favor. Share this episode with any first home buyers that you know so we can help more people like you feel clear, calm and confident when purchasing their first property. You can join our Facebook group first home unlock to continue the conversation with other first home buyers or if you're ready to unlock your first home you can book a get to know you chat by using the link in the show notes or by going to firsttime unlock.com.au. Before we go just a reminder that everything we share on this podcast is general and nature and not tailored to your personal situation. We always recommend seeking advice from a qualified and experienced professional when making financial decisions.