Once you've done a home loan health check and mortgage rate comparison, if you decide you do want to switch home loans, you'll have to refinance your mortgage.
How refinancing works:
- Imagine you have a mortgage with Lender X, with an interest rate of 4.50%, outstanding debt of $300,000, and a remaining loan term of 20 years.
- After comparing more than 100 lenders, you decide you like the look of Lender Y, which is offering a similar home loan to Lender X, but with a mortgage interest rate of just 4.00%.
- If you decide to refinance, Lender Y would repay your debt to Lender X – you would owe nothing to your old lender, and instead owe $300,000 to your new lender.
However, before you sign on any dotted lines, it’s important to ask yourself a few questions, such as:
Did you check the comparison rate?
When you make a home loan comparison as part of a home loan health check, it’s important to consider the 'comparison rate', and not just the 'advertised rate'.
A home loan’s advertised rate only indicates the cost of mortgage interest, and doesn't include fees or other charges. Sometimes a home loan with a low interest rate but high fees can actually cost more over the long term than a home loan with a higher interest rate and low or no fees.
A home loan’s comparison rate combines its interest rate with the cost of its standard fees and charges, giving you a better idea of its total overall cost. This can provide a quick and simple way to compare home loans and provide a better idea of which offers may cost more over the long term.
With some loans, there will be no gap between the advertised and comparison rates, while others will have a significant gap of one percentage point or more.
Will you need to pay fees? And what for?
If you do refinance, you may have to pay a range of fees to both lenders.
Your old lender may slug you with a discharge fee, and if you're exiting a fixed-rate loan ahead of schedule, you will probably have to pay break costs as well.
Your new lender will probably charge you any combination of standard set-up fees – establishment fee, valuation fee and settlement costs. All these fees could easily add up to more than $1000.
Has your property’s value fallen?
If your property is located in an area where values have fallen in recent years, refinancing could potentially cost you more money than you expect.
For example, imagine that when you bought the property it cost you $500,000 and you borrowed $400,000. That would have given you a loan-to-value ratio (LVR) of 80% and allowed you to avoid paying Lenders Mortgage Insurance (LMI), which is generally only charged if you have an LVR above 80%.
Now imagine that two years later, you've decided to refinance, having reduced your debt to $385,000 – but you’ve also seen the value of your property fall to $475,000.
When Lender Y values your property as part of the refinancing process, it will discover that your LVR is now 81% and charge you LMI, which could cost you thousands.
Are you refinancing into a longer home loan?
When you refinance, you may want to check if your new loan term matches your old one. The default loan term for many mortgages is 30 years, so if you're not careful, you could accidentally exit from a mortgage that has 20 years left to run with Lender X, and sign up for a new 30-year mortgage with Lender Y.
A longer loan term means you’ll be in debt and paying interest for longer. This could end up costing you more money, even if the mortgage interest rate is lower:
- The total repayments for a $300,000 mortgage over 20 years at 4.50% is $455,508
- The total repayments for a $300,000 mortgage over 30 years at 4.00% is $515,609
- That's a difference of over $60,000!
Hypothetical examples are for illustrative purposes only. Does not account for fees or interest rate changes over time. Source: MoneySmart.
