Introductory rate loans: What happens when the honeymoon is over?
Honeymoon loans are just one of many products offered by lenders. But like all honeymoons, the good times can come to an end, so it’s important to do your homework to avoid getting caught out!
What is a honeymoon loan?
Honeymoon loans are also called introductory rate loans, because they offer a period at the beginning of the contract when the interest rate is lower than the standard variable rate.
This period of time can be as short as six months and stretch as far as three years from the start of the loan.
Lenders use the introductory rate as a marketing tool to attract new business and gain market share, but the loans do not come without risk and potentially come with additional costs to the borrowers in the long run. So, before considering this type of loan, it is critical that a borrower understands the product, the long term costs and the risks.
There are two types of introductory rate loans:
1. Discounted Variable Rate. The interest rate is set at a fixed percentage below the standard variable rate for the honeymoon period before reverting to the standard variable rate at the expiry of the introductory term. It will move in line with changes in the variable rate, but the discount will remain in place and the difference between the two rates will be unchanged until the introductory period is over.
2. Discounted Fixed Rate. The interest rate is fixed for a period of time at the beginning of the loan, and like all fixed rate loans, won’t move with changes in the variable rate. The lenders offer a lower rate than the variable rate and at the moment, the fixed rate period is for one, two, or three years.
I don’t know any borrower who would not like a lower rate on their home loan, so why aren’t they more common? The simple answer is that while these loans are appealing at first glance, there are several negative considerations. If borrowers ignore these considerations in the rush to secure a low rate, they may be left with the exact opposite of what they want, that is, a costly and unsuitable loan. Here are just a few of those potential pitfalls.
1. Cash flow hit. Discounted fixed rate loans are now the most common form of introductory rate loans being offered. Lenders offer a fixed rate below the prevailing variable rate so they can advertise a low headline rate. The problem is that when the fixed rate expires, the loan usually reverts to the lender’s Standard Variable rate and this can expose the borrower to a real hit to their cash flow if rates have risen. Borrowers that are vulnerable to upward movements in interest rates and their loan repayments are therefore at significant risk of not being able to afford their loan repayments.
2. Reduced flexibility. Under the discounted fixed rate offer, borrowers can lose options such as redraw and offset accounts. So they may have a lower rate, but the loan may have no flexibility.
3. Limited additional repayments. During the honeymoon period, particularly for discounted fixed rate offers, the lender may limit additional repayments to the loan, eliminating one of the two main benefits of the product (i.e. the ability to take advantage of the low rate to reduce the loan to a manageable level before the introductory period is over).
4. Higher fees. These loans may carry higher fees offsetting the gains of the lower rate so the borrower does not realise the savings they were banking on.
5. Other penalties. The cost of discharging the loan, or switching during the introductory period, can incur fees. So if the loan is paid out for any reason, there is the potential for the borrower to be hit with substantial penalties.
Despite the above negatives, there are circumstances when the loan can match the needs of a borrower and would be a suitable option.
The lower rate during the honeymoon period may provide two main advantages.
1. Reduced initial costs. It softens the cash flow shock for new borrowers who may be purchasing their first home, starting a family, or early in their careers with lower incomes. The lower rates and repayments give these borrowers the chance to establish themselves, get their home set up and cement their income streams before the loan repayments increase.
2. Accelerated debt reduction. Secondly, the lower repayments during the honeymoon period provides the borrower with the opportunity to make extra repayments while the rate is low (subject to the conditions of the loan) so they can accelerate the reduction of their debt in the early years of the loan to reduce their risk.
Like all honeymoons, the borrower will have to return to normal life at some point and the reality hit may have long term impacts. So if you are considering this type of product, make sure you do your homework first and ensure the specific product suits your personal circumstances. If in doubt, consult your finance expert or the team at Switzer Home Loans and let them do the leg work on your behalf.
Adrian Sheahan is the manager of lending operations at Switzer Home Loans. Contact him today for a free loan health check.