Five commonly confusing real estate finance terms you need to understand

Five commonly confusing real estate finance terms you need to understand

Five commonly confusing real estate finance terms you need to understand

For first-timers, hearing property finance terminologies can be very confusing. Even the most experienced buyers and sellers sometimes also get confused with jargons flying around the real estate world.

If you want to increase your success rate before making a big real estate move, you must do your due diligence and learn to understand these five common but confusing property finance terms.

Cash Rate

The cash rate is a metric set by the Reserve Bank of Australia (RBA). It is the interest that every bank has to pay on the money it borrows, or in its own words, the "overnight money market interest rate". It’s a benchmark from which interest rates for home loans and savings are based.

The cash rate target is set every month by the RBA board. If the cash rate is lower, it makes home loans more affordable, and it’s usually done to spur borrowing and drive up economic activity. When the cash rate is set higher, it increases the cost of borrowing and helps moderate economic growth and curb inflation.

In most cases, when the cash rate goes up or down, the rate borrowers pay on variable loans also changes, although not always by the corresponding amount.

Loan-to-value ratio

Banks and other financial institutions assess the lending risks before approving a mortgage. They do this using the loan-to-value ratio. It measures the relationship between the loan amount and the market value of the asset securing the loan, such as a property.

To determine your LTV ratio, divide the loan amount by the value of the asset, and then multiply by 100 to get a percentage.

Banks deem a mortgage less risky if the loan-to-value ratio is lower, such as 60 or 70 per cent. If the owner defaults and the bank forces a sale, there is a lower chance that the property’s value will be less than the loan.

If there’s a higher LVR in a property purchase, such as above 80 per cent, there’s often a condition accompanying the loan, and that is usually that the borrower buys lenders mortgage insurance.

Lenders Mortgage Insurance

Lenders mortgage insurance (LMI) protects lenders from financial loss if the borrower defaults on a home loan and there is a “shortfall”. A shortfall happens when the value of the property does not cover the outstanding balance you owe to the lender.

LMI is usually a one-off payment made by the borrower at settlement, and is a requirement if your loan-to-value ratio is more than 80 per cent. This is because an LVR of more than 80% is considered to be a higher risk to the lender.

Some borrowers with deposits less than 20 per cent choose to pay LMI to get into the property market quicker. Other buyers with smaller deposits may have a parent act as guarantor to avoid paying LMI at all, and it may be waived for borrowers in certain high-income professions.

Home loan pre-approval

A home loan pre-approval is when your lender gives you conditional approval to borrow money for your ideal property after assessing your financial situation. At this stage, nothing is set in stone and the lender could still decline your final home loan approval.

A pre-approval gives buyers an idea of how much they can afford, as well as the confidence to pursue properties within a set price bracket and submit offers. It’s usually valid for 90 days and can be extended if need be with up to date information.

Before you finally decide to buy a property or bid at an auction, you should get a pre-approval first as auction sales are unconditional and cannot be subject to additional finance approval.

Offset account

An offset account is a transaction account linked to your home loan. You can make deposits or withdraw from it as you would with a regular transaction account.

The big difference is that when you hold money in an offset account over a period of time, you can reduce the amount of interest charged on your home loan. The higher the balance and the longer the period, the less interest you’ll pay.  And this could help you pay off your loan sooner.

When determining the interest to be charged on the loan, any money in the offset account is deducted from the loan balance. For example, a borrower with a $500,000 loan and $50,000 in their offset account will only pay interest on $450,000. However, no interest is earned on money in an offset account.

An offset account can be a good way to reduce the interest charged on your home loan, while also giving you access to your money whenever you need it.

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