Sean Hamilton: Structured Debt through Personal Loans
In Aotearoa we have a deep love of housing to create wealth. It’s become a national past time. This subject holds such sway in the public consciousness that it dominates headlines. It also spearheads political agendas. Given this, it’s important for anyone considering property as a means to generate their own wealth, to understand how home loans work to maximise the benefit.
This article will summarise what I consider to be fundamentals with home loans, but keep in mind that there are many publications, pod-casts and professionals dedicated to this topic. It’s important to do your research and keep a broad mind, so you are aware of what best fits your circumstances. This is a longer than usual article, because home loans are a complex and multi-faceted topic, and there is a bit to cover.
Owning a house in colonised Aotearoa is a priviledge. I believe that to get ahead in our modern society in this country, we must work within the system available to us to generate wealth, while trying to challenge it for the betterment of future generations. Property plays an important role in this, and for the majority, to get on the property ladder means getting a home loan.
Before examining home loans though, we first need to understand some of the steps to get a foot in the door.
In order to qualify for a home loan there is often requirements to meet with most lenders. First, a deposit, which along with the home loan, will be used to buy property. Secondly, a history of good financial management, such as credit score, savings history and account conduct of other banking products. Lastly, be able to afford the new home loan amount, as exhibited by meeting lending criteria as set out by the lender. The above steps can take time to develop, so planning for them early is the best approach.
However, don’t be dismayed if time isn’t on your side, there are always alternative approaches to property ownership. These could include teaming up with others, such as family. Getting the deposit from other sources, such as KiwiSaver, investments, or family. Remember too, that home ownership isn’t for everyone. Renting, co-habitation and other living arrangements are all valid.
This brings us to an important consideration, what are the benefits of wealth through property?
Property is tangible. You stand on the land and sit in a house. Housing in particular is favoured by banks as security when lending to customers, because it is always in demand and generally holds its value well. Despite the growth of property value fluctuating each year, the value tends to increase over time. It has stability in this way. People will always need places to live and work, so property plays a crucial role in our society to fulfil these needs. Much of our economic system is built around this notion.
Kiwis have a love/hate relationship with property. Those that have it, love it, those that don’t, hate, but still want it. I say this tongue in check, of course, but it does help to illustrate that as a nation, because of the obsession with property, it is a serious contender for generating wealth, due to its overall desirability. To generate wealth, property needs to be realised, either by selling it, for a gain, or borrowing against it, to create other opportunities.
So, what role do home loans play in relation to property? Unless you have a lot of cash and can literally buy outright, you may rely on taking out a loan to purchase property. This is the case for the majority of us. Most of us don’t have the levels of cash required to buy property without needing a loan, which is where banks and other financial institutions come into play. Home loans help to pay for the property, and then have to be paid back over time.
Home loans have two distinct types - structured and unstructured. These can then be further broken down into fixed, floating, revolving and offset loans. It’s possible to have a combination of all of these, or just one type, but it very much comes down to what suits your personal situation. Home loans can generally be taken out over a 30-year period in Aotearoa. This helps spread the cost of the repayments over a longer term, but be mindful, as with any loan, the longer it takes to pay off, the more interest you’ll typically pay, increasing the overall amount to be repaid.
One of the keys to wealth from property, is to pay back the lending as fast as possible, without getting into financial difficulty. This can be achieved by structuring the loan to increase repayments above the minimum threshold. It’s possible to also make lump-sum payments off the loans, for instance, from a commission, or bonus. Offset loans and resolving loans can be used to help reduce the average loan balance and thus interest owed each month, helping to pay if off faster. All home loan structures can be daunting to anyone not familiar with them, remember to seek advice, and always ask the lender, to explain more and help you achieve the best structure for your circumstances.
Let’s cover off what each type of home loan means in more details.
Table Loan: This is the most common type of home loan and falls into the structured type. You can usually choose a term up to 30 years with most lenders. Most of the early repayments pay off the interest, while most of the later payments pay off the principal (the initial amount you borrowed). Table loans provide the discipline of regular payments and a set date when they will be paid off.
Interest Only Loan: Another structured type of loan, repayments are set to pay the interest portion only, not the principal, so the payments are lower. Some borrowers take an interest only loan for a year or two (the term is usually restricted by the lender) and then switch to a table loan for the remaining term of the loan. This loan structure is preferred by investors and those who expect to repay their loan in a set period of time, such as when flipping a property and trying to make capital gains.
Straight Line Loan: Straight line home loans repay the same amount of principal with each repayment, but a reducing amount of interest each time. These are uncommon in the local market. Repayments start high, but reduce in a straight line over time. There can be a benefit in trying to pay less interest overall, but a table loan could be better utilised with higher repayments in comparison.
You can take a table, interest only and straight line loan with a fixed interest rate or a floating interest rate.
Revolving Home Loan: Sometimes also called a flexible loan, these act like an overdraft, secured by the property. Pay is directed straight into the account then bills and other expenses are paid out of the account when needed. By keeping the loan as low as possible at any time, you pay less interest because lenders calculate interest daily. You can make lump-sum repayments and redraw money up to the limit of the facility. Some revolving loans gradually reduce the credit limit to help pay it off. These loans require discipline and if the borrower is organised, can be used to pay off the home loan faster. This also suits people with uneven income as there are no fixed repayments. Putting surplus funds into this account rather than a separate savings account will give bigger interest savings and also avoids the tax on the savings account interest. These loans typically have a floating interest rate, moving up and down.
Off-Set Home Loan: These are designed to reduce the amount of interest you pay on your loan. Typically, interest is payable on the full amount of a loan. But by linking your loan to any savings or everyday accounts you have, you only pay interest on the amount of the loan minus the balance of the other accounts. For example, someone with a $500,000 mortgage and $50,000 in savings would only pay interest on $450,000. The more cash you have in each linked account each day, the less interest paid, because interest is calculated daily. However, the linked savings accounts do not earn any interest when they offset a loan. Despite this, interest on debt is typically higher than the interest you would earn on savings. These loans also have a floating interest rate.
Fixed Interest Rate: A fixed interest rate is a home loan interest rate that doesn’t move up or down, for a set period of time (term). This term is agreed between the borrower and lender and can range from 6 months to 5 years usually. Each different term for the fixed period has a different interest rate associated with it. Its worth noting that making lump sums or breaking the fixed period can sometimes have a penalty associated with it. Fixed loans have a set repayment which can bring certainty for the borrower and make it easy to budget around. Payments can typically be made weekly, fortnightly, monthly and some times quarterly.
Floating Interest Rate: These loans are sometimes also called variable loans – because the interest rate can vary. These are similar to fixed loans, but the interest rate can move up or down and usually linked to the Official Cash Rate (OCR) from the Reserve Bank of New Zealand / Te Pūtea Matua (RBNZ). This can make this type of a loan unpredictable. Lump sum payments can usually be made without penalty, so extra income can be utlised to save up and knock off more of the loan. Repayments are made in similar frequencies as the fixed loans. You can also increase your repayments more easily than on fixed loans.
Having covered off the different types of home loans, from structures to interest rates we can examine how wealth is created via home loans and property. Strip back all the layers and complexity of home loans and it comes down to one thing; they are a means to an end. That end is to pay them off as fast as possible. When that is achieved, any capital in the property is now possible to be realised by the owner. This means that the more of the loan that is paid off, when a property is sold, the more wealth the owners get. This is also why its important to consider that when taking out a home loan, do you have enough of a deposit to minimise the amount you need to loan? The more deposit you have, the less loan required. The less loan required, the less interest to be paid back. The quicker a loan is paid back, the less interest is paid to the lender. All of these facts mean that there is more money from your income to be utilised in other ways to create wealth and live a more comfortable lifestyle.
Another important factor of wealth through property is by acting as an investor. This business-like approach to property has helped to fuel many cycles of increasing prices, but it isn’t the only factor. It has also seen the rise of a middle-class generation over the last 3 decades that has buoyed itself upwards with wealth at the expense of those who aren’t on the property ladder. This is slowly changing, but will continue to drive an intergenerational wealth gap, especially for Māori.
Property investors typically use home loans to leverage the capital value of property. By borrowing as much as possible and using the lending to buy more property, investors can then have tenants rent their property to make the loan repayments. When the property is sold, the gains are usually made by seeing an increase in the overall value of the property over time, as the new property buyer pays more for the house than what the investor initially paid. Property investment is becoming much harder with restrictions from the RBNZ, Government and Banks all trying to dampen down the appetite for this type of wealth generation, so that more people who aren’t investors can get into a house of their own.
At the time of writing this article, for many everyday people, it is incredibly hard to get onto the property ladder or take out a home loan. Government regulation, banking criteria, deposit amounts and property values continue to push the goal of owning a home out of the hands of so many. With this in mind, potential borrowers and home owners must take advantage of all the tools at their disposal. Seek financial advice. Talk to professionals such as mortgage brokers to give options about where obtaining a home loan might be possible from. Check out many of the local financial support digital tools and websites. Put a savings plan in place. Act now like your paying for a home loan, by setting your budget in a way to show a potential lender that you can make the repayments. Take steps, suited to your circumstances to make the goal achievable.
Home ownership is an important part of the wealth journey for so many. Often it is a retirement plan in itself. However, the emergence of KiwiSaver 15 years ago changed the stake for retirement in Aotearoa. It also helps many get into the property market with some of the balance being able to be withdrawn early for a house deposit. KiwiSaver has become a crucial factor in the future of many people and how they will plan for the twilight years of their life. We’ll examine KiwiSaver in the next article.
Disclaimer: The information in this article is provided as general information. It is not intended as financial advice for the purposes of the Financial Services Legislation Amendment Acts 2019 (FSLAA). No investment objectives, financial situation and particular needs of any particular person has been taken into account in the publication of this article. Professional advice should always be sought before taking out any financial product.