Why do banks bombard us with incomprehensible jargon? And what’s with all those annoying acronyms?
If you don’t know your LVR from your LMI or your balloon payments from your balance transfers, you’ve come to the right place.
We’re going to translate all that annoying finance-speak into English, covering everything from home loans, car loans, personal loans and credit cards to bank accounts, term deposits, superannuation and investments.
Fancy doing some of that negative gearing everyone’s talking about? Negative gearing is when you own an investment property and the costs (interest payments, maintenance, property management fees, council rates, land tax) exceed the income (rental payments). You can then use that loss to reduce your taxable income and pay less tax.
It’s generally a good idea to get a pre-approval before you start looking for a property. A mortgage pre-approval is when a lender tells you it is willing to lend you a certain amount of money (subject to conditions). That way, you know the maximum amount of money you can spend on your property. If you don’t get a pre-approval, you might commit to buying a home and then discover that no lender will give you the money to buy it.
Lenders generally expect you to have an LVR of 80 per cent or less. An LVR, or loan-to-value ratio, is the share of money that you have to borrow to buy a property. Imagine you had $100,000 for a deposit and decided to buy a $500,000 property – in that case, you would have to borrow $400,000 out of that $500,000, giving you an LVR of 80 per cent.
Some lenders will allow you to have an LVR above 80 per cent if you’re willing to take out LMI or lender’s mortgage insurance. LMI is an insurance policy that protects the lender if you default on your mortgage and the lender forcibly sells your home but fails to get back all the money you owe. In that case, the LMI insurer would cover the bank’s losses.
The most common type of home loan is a principal-and-interest home loan or a P&I loan. This is when you gradually reduce the principal (or loan amount) and make regular interest payments on however much of the loan is outstanding. For example, if you take out a $400,000 principal-and-interest mortgage over 30 years, you will pay off the $400,000 over three decades and also pay interest for that entire period.
You can also opt for an interest-only home loan or an IO home loan. This is a loan where you only pay interest; you don’t reduce the principal. However, at some point, your interest-only mortgage will revert to a standard principal-and-interest mortgage. For example, imagine our hypothetical 30-year, $400,000 home loan included a five-year interest-only period. During the first five years, your payments would be less than someone paying principal and interest. However, when the loan reverted to a P&I loan, your payments would be more than someone who had been paying principal and interest the whole time. Why? Because now you would have to repay the $400,000 over 25 years rather than 30 – and you’d also have to keep making interest payments.
The most common type of interest rate – regardless of whether you opt for a principal-and-interest mortgage or an interest-only mortgage – is a variable interest rate. If you take out a variable-rate home loan, your lender can increase or decrease the interest rate whenever it likes.
Don’t be surprised if lenders refer to their variable rate as an SVR. This means standard variable rate.
Lenders might also offer you a DVR or discounted variable rate. This is a cheaper version of the SVR – for example, a lender might have a standard variable rate of 4.90 per cent and a discounted variable rate of 4.20 per cent.
If you don’t like the uncertainty of variable rates, you can opt for a fixed interest rate. With a fixed-rate home loan, the lender can’t change the interest rate during the fixed-rate period. Please note that when the fixed-rate period ends (which is usually anywhere from one to five years), your mortgage will probably revert automatically to a variable-rate loan.
Can’t decide whether to go variable or fixed? In that case, you can take out a split loan. This is where part of your mortgage is variable and part of it is fixed. (Technically, you’ll actually be given two separate mortgages.) Most lenders will let you choose whatever split you like, whether it’s 50 per cent fixed and 50 per cent variable or 80-20 or 40-60.
Whether you want your mortgage to be variable, fixed or split, pay close attention to the comparison rate when doing your research, rather than just the advertised interest rate. The advertised rate is the amount of interest you will pay – say, 4.25 per cent. However, the ‘real’ cost of the loan will be higher if you have to pay fees when you take out the loan and then during the life of the loan. The comparison rate includes both interest and fees – so a loan with an advertised rate of 4.25 per cent might have a comparison rate (or ‘real’ interest rate) of 4.50 per cent. Please note that the comparison rate might be slightly inaccurate, as it assumes the customer is borrowing $150,000 over 25 years.
Home loans and interest rates
Looking for a home loan? Here are nine terms about interest rates you might hear:
- Variable interest rate
- Fixed interest rate
- Split loan
- Comparison rate
- Honeymoon rate
Another thing to check is whether the advertised interest rate is a ‘standard rate’ or a honeymoon rate. A mortgage might have a standard rate of 4.15 per cent and a two-year honeymoon rate of 3.75 per cent – so the borrower pays 3.75 per cent for the first two years and then 4.15 per cent afterwards. Lenders offer honeymoon rates so they can quote lower numbers in their advertising and attract more customers. You should always keep an eye on when the honeymoon period is going to end, so you can budget accordingly.
If you want to save money on your home loan, you might want to get an offset account, which is a transaction account linked to your mortgage. An offset account allows you to reduce the amount of interest you pay. For example, if you take out a $400,000 mortgage and deposit $50,000 in your offset account, your lender will charge you interest on only $350,000 rather than $400,000.
A redraw facility allows borrowers to get ahead of their mortgage repayment schedule and then ‘redraw’ or claim back any of this extra money. As with an offset account, if you owe $400,000 and have $50,000 in your redraw facility, you will be charged interest on only $350,000. However, it’s often harder to withdraw money from redraw facilities than offset accounts.
If you borrow $400,000 to buy a $500,000 investment property, that means you’ve got $100,000 of equity or ownership value. Your equity will increase if you reduce your mortgage and the value of your property rises. For example, imagine that after five years you’ve reduced your mortgage to $350,000 while your property’s value has increased to $550,000. In that case, you would now have $200,000 of equity.
At that point, you might decide to move your $350,000 mortgage to a lender that’s offering a lower interest rate. This is known as refinancing. In this situation, Lender 2 would pay $350,000 to Lender 1, which would mean that your debt with Lender 1 would be cleared and you would now owe $350,000 to Lender 2.
You might be refinancing from a non-bank lender to a bank. A non-bank lender is a financial institution that provides loans but which does not have a banking licence. Non-bank lenders often provide niche products that mainstream banks are reluctant to offer, such as mortgages for borrowers who are self-employed or have bad credit histories. These home loans often have higher interest rates than ‘vanilla’ home loans; if you can build up a good repayment history over several years, you might be able to refinance from the non-bank lender to a bank.
The better your credit score, the more likely you are to qualify for a home loan or any other credit product. A credit score is a rating that reflects your history in managing credit products, which may include car loans, credit cards, internet plans, phone plans – anything where you either took out a loan or bought now and paid later. The higher your credit score, the more willing a bank will be to give you a home loan.
Your credit score fits within a system known as comprehensive credit reporting. Under comprehensive credit reporting, which was introduced in 2014, credit scores are calculated based on both positive and negative activity with your loans and post-paid products. A positive event would be paying on time; a negative event might include paying late, missing a payment altogether, being rejected for a credit application or filing for bankruptcy. Under the old credit reporting system, only negative events were included in a consumer’s history; under comprehensive credit reporting, positive events are also included, thereby providing a more balanced view of a consumer’s ability to manage credit.
If your credit history makes it hard for you to qualify for a mortgage, one possible solution might be to take out a guarantor home loan. This is a home loan where another party – such as parents, relatives or close friends – provides a legal guarantee to the lender that they will stand behind your mortgage. That means that if, for whatever reason, you failed to repay the home loan, your guarantor would be expected to repay it on your behalf.
Let’s change the script. Imagine you’ve lived in an owner-occupied property for a few years and you’ve decided to upgrade to a nicer suburb. You find a place you love but there’s one problem – you don’t have the money to buy it because you’re still in the process of selling your current place. One possible solution might be to take out bridging finance, which is a loan that acts as a ‘bridge’ between your two homes. Bridging finance is typically a short-term interest-only loan that you use to buy the new property and then repay when you sell the old property.
If organising a home loan sounds stressful, confusing and time-confusing, you can outsource the work to a mortgage broker. Most mortgage brokers (also known as finance brokers) don’t charge borrowers for their services; instead, they receive commissions from lenders for originating mortgages on their behalf. A typical broker works with between 10 and 30 lenders; that means they are familiar with the products and policies of these lenders and can organise a home loan for you with one of these lenders. A good mortgage broker will learn about your financial position and life goals, and will then recommend the home loans that are best-suited to your unique circumstances.
When you take out a car loan, you’ll hear many of the same terms that are used with home loans, such as credit score, pre-approval, LVR, variable interest, fixed interest, comparison rate, honeymoon rate, redraw facility, refinancing, non-bank lender and finance broker.
Another term you might hear is balloon payment, which is a one-off payment you might have to make at the end of your car loan. Why? Well, some car loans allow you to reduce your monthly repayments during the life of the loan in return for making a balloon payment at the end of the loan. However, you don’t get something for nothing, so if you opt for a balloon structure, the combined cost of the lower repayments and balloon payment will be higher than if you choose higher repayments and no balloon payment.
The moment you drive your car out of the lot, depreciation will begin. Depreciation is when the resale value of your car (or any other asset) declines due to age. There is no set formula, because different car models depreciate at different rates. Also, some cars are subjected to more wear and tear than others. As a very rough guide, your car might lose 25 per cent of its value in its first year and then 15 per cent in each subsequent year.
Personal loans generally have lower interest rates when they’re secured. A secured personal loan is one that’s connected to a form of ‘security’ or collateral. This security will be a sellable asset such as a home, car or boat. The idea is that if you fail to repay the personal loan, the lender can seize the security, sell it and then recoup its money.
Unsecured personal loans generally have higher interest rates because lenders regard them as riskier. Why? It’s because if you default on the loan, the lender can’t seize an asset to pay off the debt. The reason borrowers opt for more expensive unsecured loans is because they’re either unwilling or unable to offer the lender an acceptable form of security.
Some people use personal loans as part of a debt consolidation strategy. Debt consolidation is where you use a new loan to pay off one or several old loans. For example, imagine you have two credit cards – the first has $8,000 debt and charges an interest rate of 17.99 per cent, while the second has $6,000 debt and charges 19.99 per cent. You could consolidate that $14,000 of credit card debt by taking out a $14,000 personal loan at, say, 8.50 per cent, and then using that personal loan to pay off your credit cards. This debt consolidation would give you two advantages – you’d be charged less interest and you’d only have to manage one product instead of two.
A credit card balance transfer is a form of debt consolidation. A balance transfer involves moving the debt from one or more credit cards onto a new credit card. There are three reasons why people do balance transfers. First, the new card might charge a lower interest rate than the old card. Second, the new card might charge lower fees than the new card. Third, many credit card providers offer balance transfer specials – for example, they might charge you 0 per cent interest on your existing debt (although not new debt) for, say, 12 months, thereby giving you time to pay off the debt without accumulating any more interest.
A credit card’s interest rate is technically known as the purchase rate. This is applied any time you make a purchase with your credit card.
Sometimes, the purchase rate is also known as the APR or annual percentage rate.
Why doesn’t money make cents?
If you know all 10 of these finance acronyms, you’re a genius.
Credit cards also have another interest rate, known as the cash advance rate. This is applied any time you use your credit card like a debit card.
Almost every credit card offers a certain number of interest-free days for purchases – say, 44. That means that your credit card provider will wait up to 44 days before charging you interest on that purchase (assuming you haven’t repaid the debt in the meantime). Pay close attention if your provider uses “up to” when describing its interest-free period (as almost all do). In those situations, the interest-free period begins not when you make a purchase but at the start of a billing cycle. Most billing cycles last for 30 days – say, from 1 January to 30 January. So in this case, the 44-day interest-free period begins on 1 January and ends on 14 February. That means that if you make a purchase on 1 January, you get the full 44 days, but if you make a purchase on 30 January, you get only 14 days.
Sometimes, businesses will ask for your credit card CVV when you shop online. The CVV, or card verification value, is either a three-digit number (Visa and Mastercard) or four-digit number (American Express). Visa and Mastercard place the CVV on the back of the card, in the signature panel. American Express places the CVV on the front of the card, to the right of centre.
Sick of manually paying your monthly phone bill, internet bill, health insurance bill and a million other bills? One solution would be to set up a direct debit, which is an automated payment from your bank account to another party’s bank account. With a direct debit, you control the payment – who gets it, when they get it and how much they get.
If you’re also sick of carrying a wallet with you, you can use a digital wallet when you’re out and about. A digital wallet is an electronic device (such as a smartphone or Fitbit) connected to your bank account. When you want to make a payment, you scan the device just like you’d scan your credit card or debit card.
Another way to make (and receive) payments is via the NPP or New Payments Platform. Unlike the traditional payments system, which can take up to three business days to send money between accounts, the NPP transfers money almost immediately, 24 hours a day, 365 days a year.
Users of the NPP can receive money by registering for a PayID, which a more user-friendly way to identify account-holders than the current system of account numbers and BSBs. Your PayID can be your phone number, email address or any other easy-to-remember identifier.
When it comes to savings accounts, not all interest rates are created equal. That’s because there are interest rates within interest rates. The first of these is the base interest rate, which is the minimum interest rate you are guaranteed to receive.
The second type of interest rate to be aware of is the maximum interest rate, which is what you’ll be paid if you meet certain conditions. For example, a savings account might offer a base interest rate of 1.50 per cent, but pay a maximum rate of 2.50 per cent if you make at least one deposit and zero withdrawals in a particular month. Other lenders might ask you just to ensure your balance is higher at the end of the month than the start. Or you might have to do nothing more than use another of the lender’s products, such as a credit card.
The other type of interest rate you need to know about is a bonus interest rate, which is a short-term incentive lenders offer to win your business. For example, a savings account might pay 3.50 per cent for the first four months and then a standard rate of 1.50 per cent from that point on.
Savings accounts generally pay compound interest, which means that you not only earn interest on your original investment, but interest on your interest. For example, imagine you invested $100 at a rate of 3.00 per cent per annum. After one year, you would have earned $3 interest, thereby increasing your savings to $103. In year two, you would be paid 3.00 per cent of $103 rather than 3.00 per cent of $100, which means you’d earn $3.09 of interest. In year three, you’d earn $3.18 of interest.
Simple interest is the opposite of compound interest, because you don’t earn interest on your interest – only on your original investment. So if you invested $100 at a simple interest rate of 3.00 per cent, you’d receive $3 of interest in year one and $3 of interest in year two and $3 of interest in year three, and so on.
As a general rule, money invested in an Australian savings account is protected by the government guarantee. Under the government guarantee, or the Financial Claims Scheme as it is officially known, the federal government promises to reimburse you in the unlikely event that the institution where you have a savings account collapses and your money is lost. However, the government guarantee comes with two conditions. First, the government will limit your reimbursement to $250,000 – so if you have $350,000 in the account, you will lose $100,000. Second, the institution has to be a bank, building society or credit union that is incorporated in Australia and authorised by APRA (the banking regulator).
Wondering why term deposit interest rates move up and down? One reason is that lenders take their lead from the cash rate, which is set by the Reserve Bank of Australia. The cash rate is the overnight money market interest rate that banks use when transacting with each other. When the cash rate goes up, lenders generally raise their interest rates for term deposits, as well as home loans, savings accounts and other products. When the cash rate goes down, they generally lower their interest rates.
As your term deposit is coming to an end, your lender will ask if you want to withdraw your money or do a rollover. A rollover is when you keep your money in the term deposit for another term – for example, if you had a two-year term deposit, the money would be reinvested for another two years. But while the new term length would be the same as the old term length, the interest rate would probably be different. That’s because you’d be given whatever the current interest rate was for two-year term deposits, rather than whatever the interest rate was when you opened the term deposit.
Most Australians have their superannuation in an accumulation fund, a fund in which your money grows – or accumulates – over time. When you stop working, your retirement savings are whatever is in your accumulation fund at the time.
A defined benefit fund is different. If you retire with a defined benefit fund, you get paid a specific – or defined – amount of money. For example, you might receive a monthly payment equivalent to 80 per cent of your final monthly salary. Or you might receive a one-off lump sum equivalent to six times your final salary. Defined benefit funds are becoming progressively less common; many don’t admit new members.
If you don’t choose a superannuation fund, your employer will pay your superannuation into a fund that offers MySuper. A MySuper account is a basic, low-fee account with a limited number of features and a single investment option.
Want to grow your super? Salary sacrificing is one way. With a salary sacrifice, you can ask your employer to pay some of your salary into your superannuation account instead of your bank account. (This salary sacrifice would be in addition to the compulsory superannuation contribution your employer would have to make on your behalf.) For example, if you had a salary of $60,000 (plus compulsory super), you could ask your employer to pay you $55,000 and salary sacrifice $5,000. This $5,000 salary sacrifice would then be taxed at a maximum rate of 15 per cent, which would generally be less than the rate at which your salary would be taxed.
Where to invest your money
Here are eight ways you can use your money to make money:
- Leave it in a savings account
- Lock it away in a term deposit
- Salary sacrifice it into superannuation
- Put it into managed funds
- Use it to trade equities
- Use it to trade ETFs
- Use it to trade cryptocurrencies
- Buy an investment property
Don’t forget that all options involve varying levels of risk.
There are two ways in which money can be paid into your superannuation account – through a concessional contribution or a non-concessional contribution. Concessional contributions (which include compulsory super payments and salary sacrifices) are made with income that hasn’t yet been taxed. Once the concessional contribution reaches your super fund, it is taxed at the 15 per cent superannuation rate. Concessional contributions are capped at $25,000 per year.
If you want to add more than $25,000 per year to your superannuation account, you can also make non-concessional contributions, up to a limit of $100,000 per year. Non-concessional contributions are made with income that has already been taxed, so it does not get taxed a second time once it reaches your super account.
Most Australians pay professional managers to look after their superannuation. But you can choose, instead, to set up a self-managed superannuation fund or SMSF. Self-managed super funds give you greater control of your investment decisions. However, SMSFs come with strict compliance obligations, which can be complicated, time-consuming and expensive to meet.
If you use your self-managed super fund to invest in property, you’ll have to enter into a limited-recourse borrowing arrangement or LRBA. This protects your super funds assets if you’re unable to pay back the property loan. With regular home loans, which use full-recourse borrowing arrangements, the bank can seize your home and any other assets if you default on the mortgage – whatever it takes for the bank to get its money back. But with an SMSF home loan and an LRBA, the bank can only come after the investment property. So the bank’s recourse – or entitlement to compensation – is limited.
‘Equities’ is another name for ‘shares’ or ‘stocks’. So if you play the stock market, you’re trading in equities.
ETFs, or exchange-traded funds, can take the time and complexity out of investing in equities. An ETF is a fund that holds a range of assets, and which can be bought or sold like shares. For example, imagine you wanted to invest in a mining company but didn’t know whether to choose BHP or Rio Tinto or another stock. In that case, you could buy an ETF that contained shares in, say, 50 mining companies – that way, you’d be spreading your risk rather than putting all your eggs in one or two baskets.
An index fund is a fund (often an ETF) that tracks an index or a collection of stocks that represents a particular country or sector or some other grouping. For example, you might invest in an index fund that tracks, say, Australia’s 100 biggest publicly listed companies. Instead of spreading its money equally around those 100 companies, the index fund would invest in proportion to the value of each company. So if, say, BHP represented 2.5 per cent of the value of Australia’s 100 biggest publicly listed companies, then the index fund would invest 2.5 per cent of its money (rather than 1 per cent) in BHP. If BHP’s value share increased to 2.7 per cent, then the index fund would increase its investment in BHP – and reduce its investment in one or more companies by the same amount.
A managed fund is like an index fund, but instead of blindly following an index, the company running the fund uses its own judgement on what to buy/sell and when to buy/sell. Due to this human intervention, managed funds usually charge higher fees than index funds. Also, managed funds can perform significantly better (or worse) than the general market, whereas index funds will match whatever market they’re tracking.
Over the past few years, cryptocurrencies have emerged as an alternative investment option. Cryptocurrencies differ from traditional currencies in that they are digital (no cash or coins) and are managed by organisations or companies (not central banks). Bitcoin is the world’s most famous cryptocurrency – but there are more than 1,000 others, including Ethereum, Ripple, Litecoin, Zcash, Bitcoin Cash and Dash. Cryptocurrencies, like traditional currencies, can be bought and sold in exchanges, which means their price can go up or down, which means you can make money if you know when to buy and sell.
Money and finance exam
Can you answer all 10 questions?
- What is a balance transfer?
- What is a balloon payment?
- What is bridging finance?
- What is a credit score?
- What is debt consolidation?
- What is a digital wallet?
- What are equities?
- What is the government guarantee?
- What is negative gearing?
- What is an offset account?