We borrow money to satisfy our desire to buy what we want (e.g., house, car, holiday, wedding). But when we take out a home loan we borrow the amount we need, and pay it back with interest applied on top. If we are not careful, it can lead us to paying almost double (or more) for our initial purchase.
Understanding the basic principles of a home loan can help you to achieve value from a loan and allow you to be able to make an informed decision, saving you thousands of dollars in the long run.
A loan is basically an amount of money borrowed which is to be repaid through regular repayments with interest applied.
Here are a list of common words you will see used by lenders:
- Principal = the amount of money borrowed that you have to repay;
- Interest = the fee you pay for borrowing money.
- Lender = who you borrow money from;
- Borrower = you, the person borrowing the money;
- Term = the length (in time) of the loan.
When you make repayments on your home loan you will be paying off both interest and principal (unless you are on an interest only loan).
Interest is money you will never see again; aka “dead money”. To pay your home loan off faster, you want to pay as little of this as possible to be able to get through the amount you borrow faster.
One of the secrets to paying your home loan off faster is to start with large repayments to really reduce your interest repayments when your loan is at its highest (at the beginning of your home loan). This will help you to reduce how much you owe overall.
Keep this in mind when lenders offer you interest only periods on your home loan.
Interest only periods tend to be taken at the start of a loan—when your loan is at its highest. If you can help it never, never, never pay interest only. If you do end up making interest only repayments, you’ll have to make higher repayments after the interest only period finishes, and you’ll end up paying a lot more interest than you need to.
The only exception to this is if you are an investor, but this still comes with other questions. If you do make interest only repayments, you’ll have to make higher repayments after the interest only period finishes and you’ll end up paying a lot more interest than you need to.
If you inadvertently end up on an interest only loan (which we did on our second loan—I’ll get to that later), then make extra repayments regardless (so long as there are no fees for making extra repayments).
Once you understand what you will be repaying it’s time to start taking advantage of this. Next up we talk about paying more off your principal than interest and we have a special rule to help you work this out quickly.