Top two home loan customer priorities - LMI and Offsets

Customers will typically query us on:

• Whether to pay LMI or not
• Using an offset account

[1] LMI

When I started in banking many moons ago building financial products for customers, I had a concern on how Loan Mortgage Insurance was being used. No longer. It can look expensive and only the protects the lender in case of default, but it is also advantageous for borrowers. Let me explain.

It is generally required when a 20% deposit isn't available and the Loan to Value Ratio (LVR) is above 80%. Some lenders will go to 85% before LMI is required (ask me which ones if you need that) and Mortgage Protection Insurance is still available for customers at an additional cost to LMI (ask me too). LMI can run from around $5000 to well beyond $10,000 depending on the loan size and higher LVR.

So Yes, LMI is there to protect the lender and cover APRA regulatory requirements, but it also allows lenders to make more loans available and get people into their own home sooner. This is important and the main benefit for customers, particularly first home buyers (FHBs).

In a rising market, experience shows that the cost of LMI can usually be offset in one year of house price increases

We talk to clients about LMI and, if serviceability is present, then it’s typically a good option. For example, A $16,000 LMI cost on a $600,000 loan is nominally 2.67%. Melbourne house price growth Year To Date to August is 2.7%. If you’d taken your loan out last year or in January, then you’ve essentially covered the cost of the LMI via asset value appreciation and already moved in. This can beat the alternative of remaining out of the market and trying to get to the 20% deposit mark. This needs to balanced with the often higher loan rates that are charged on loans above 80%. Your broker is in a good position to discuss that with you.

LMI and FHBs - CBA and PropTrack report found:

• FHBs households could only afford mortgage repayments on 17% of dwellings in Australia
• Despite these affordability headwinds, more FHBs are entering the market than 10 years ago
• The two biggest challenges are [1] Saving for the deposit, and; [2] Making repayments
• Three-quarters are purchasing their first home with less than a 20% deposit, using LMI or relying on govt programs
• Recognised that lower rates will improve things - for ongoing loan serviceability and approval rates

LMI can be a useful tool to assist FHBs obtaining a home loan and getting into a home.

Government LMI FHB program

Now that Government FHB programs have been brought forward to Oct 1st through participating lenders, FHBs can soon access loans skipping the LMI fee and lower interest rates, as if their loan was at 80% LVR. In light of the typical headwinds experienced by FHBs above, this is great news for FHBs.

[2] Offset Accounts (and Redraws)

Offset accounts are linked to your home loan and any balance within an offset account will 'offset' the current balance of your loan. When loan interest is calculated, it will be charged on the difference between your loan balance and the amount in the offset account. Eg. $500,000 loan balance with $50,000 in offset leaves $450,000 that will be charged interest. Offsets reduce your interest and can help repay loans faster and in general reduce ongoing repayments.

Clients will use offset as their daily account with a card and/or contactless payment on their device. Others like to keep it separate from their daily accounts, and move funds around according to their income cycles and as they see fit. Using the lenders' internet banking app is ideal for this. I recall seeing numbers on offsets were about 50/50 for those using them with cards attached or not. That is, half of us are happy to plonk all/most of our earnings into the offset and then use them for daily living expenses, while the other half treat them as savings accounts and restrict access to the funds. It doesn't matter how they are specifically used, as the main thing is they offer customers flexibility and reduce your interest costs.

I always raise the product feature of Redraw after discussing the benefits of Offsets. (I should know as I built a number of award-winning home loans with offset accounts while working in the banks! I also built the first Business Loan with redraw a long time ago for a major bank and fundamentally changed their credit policy. Fun times). The economic operation is the same - offsets and redraw allow access to surplus funds while reducing your interest costs. $50,000 in offset and $50,000 in surplus funds in your loan available for redraw, provide the same economic benefit to borrowers. Offsets are still more flexible in that they are uncapped, while some lenders have $50 minimum redraws, and others have $500.

Talk to your broker about your preferences. Offsets will require you to manage another account(s), increasing the 'cognitive load' on your loan arrangements. But as above, if the offset becomes part of your daily transaction account, then there's really no change other than moving to the new offset account. Redraws keep everything in one place and in the loan.

Offsets (and Redraws) allow you to ‘invest’ in your home loan. I mean, if your current or prospective home loan will be around 5.39% pa then any funds you put into the offset will save you 5.39% on those funds and against your loan. Could you use the funds differently? Of course, you can, and you should speak to your financial advisor about what could work for you. To my mind, the simple math is this means you’ll need an alternative investment that pays more than 5.39% pa after tax. Excluding capital growth and any tax benefits (before costs), 5.39% is probably better than any rental yield you can pick up in the market right now. Average rental yields in Melbourne residential houses and units in July were 3.5% and 4.7%, respectively. Still, well below the variable interest rate of a low LVR new loan. You should take advice from your independent financial advisor for this point. I raise here that while you may be considering what to do with the surplus funds, you can have peace of mind knowing it is giving you a 5.39% (in this example) risk free ‘return’ on your money that other investments will need to beat.

An important difference is that most home loans with offsets will charge extra. The additional cost can be in the form of monthly fees (eg. $10 per month), a Package loan with annual fees (typically from $199-$395 pa), and/or higher interest rates. Over the course of 10 years, the offset will generally cost you around $1000 to $4000 for the privilege in fees alone. If clients think their surplus offset funds will only be in the short term, or the average balance will be too low, say below $3000, then the cost of an offset may not stack up over time. The discussion then moves to whether the offset is still suitable for your individual circumstances and we also consider how you prefer to use the bank accounts. Sometimes a loan with redraw is perfectly fine.

Note too that most banks will not allow offsets or even redraws during a fixed rate term. This is why many customers opt for split loans (variable and fixed interest) to keep the offset and redraw benefit available, as well as their interest rate considerations. But there are some bank products that allow offsets on fixed rates (ask me which lenders because they are rare, and I know, as I built one of them!)

I'll cover Rent-vesting and Investors and Offsets in another post.

Disclaimer: The content of this post is general in nature and is presented for informative purposes. It is not intended to constitute tax or financial advice, whether general or personal nor is it intended to imply any recommendation or opinion about a financial product, investment position or strategy. It does not take into consideration your personal situation and may not be relevant to circumstances. Before taking any action, consider your own particular circumstances and seek professional advice. This content is protected by copyright laws and various other intellectual property laws. It is not to be modified, reproduced or republished without prior written consent.