Bigger is better for home loans

AS the memory of the global credit crunch fades, many home loan lenders are loosening their purse strings. We’re unlikely to see a rapid return to the days of no deposit home loans but there are still good reasons to stump up the biggest deposit possible.
In the mid-2000s, before the global financial crisis, financial institutions were falling over themselves to hand out home loans. We saw the development of mortgage products like ‘no-deposit’ loans that allowed people to take out a mortgage without any sort of deposit or proof of saving. Some lenders even allowed borrowers to take out loans worth more than the value of the property, adding a few thousand dollars to the loan to cover stamp duty and other purchase costs.

This sort of lending largesse may have seemed like manna from heaven for first homebuyers. But when interest rates rose in late 2009, many home owners were left financially skewered by higher repayments.

The turmoil that hit financial markets in 2008/09 also forced lenders to tighten their lending criteria, and no deposit loans were among the first casualties.

Personally I wasn’t sorry to see them go, but worryingly I’ve read recent reports that say many lenders are once again relaxing their ‘loan to valuation’ ratios (LVR).

The LVR is the percentage of a property’s value you can borrow. A more generous LVR may be welcomed by struggling first home buyers, but opting for the lowest LVR possible is a financially smart idea.

Let’s say for example that you plan to buy a home costing $400,000. Stumping up a 5% deposit would mean putting in savings of $20,000 and taking out a loan for $380,000. At an interest rate of 7.0% the monthly repayments would be about $2,685, and over the life of the loan you’d pay around $425,730 in interest assuming a 25-year term.

However as you’re borrowing over 80% of the property’s value, you’d also be asked to pay lenders mortgage insurance (LMI)– which provides no benefit to you, the borrower, whatsoever. The one-off premium would come to around $10,400 for a first home buyer.

Now let’s say that you can save a deposit of just over $80,000 in order to borrow less than 80% of this property’s value. With a deposit of $81,000 and a loan of $319,000 your monthly repayments would be around $2,255 – that’s $430 less each month than if you borrow 95% of the home’s value. Moreover, the long term interest bill will come to about $357,390, a saving of $68,340. The icing on the cake is that you won’t pay LMI.

So in this scenario, tucking away an extra $61,000 in a deposit, leaves the home owner better off by around $78,740 thanks to savings on long term interest and LMI.

The other advantage of saving a bigger deposit is that any possible future rate hikes are far more manageable. And of course you have more equity in your home from day one.

As our economy recovers and financial markets settle back to more normal conditions, home loan lenders may be willing to accept smaller deposits. This may be the only way some first home buyers will get a foothold in the market. But do be aware that there’s no generosity involved here. Savings less upfront is likely to mean paying a lot more over time.

Paul Clitheroe is a founding director of financial planning firm ipac, Chairman of the Australian Government Financial Literacy Board and chief commentator for Money Magazine.

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