I will not make any money by helping you understand housing loans, nor am I a home loan expert. I write just because I care about people and home loan decisions can have a big effect on our lives. So that you can be sure that I have given you the correct information, and also to be sure you have correctly understood what I say, you should go to your bank and ask questions about what I say below. I simply hope to point you in the right direction.

I will use numbers that apply to Australia in 2013. The numbers might be a little different in other countries but the way bank loans work is likely to be the same.

I will mention some bad things that are possible with bank loans, even though they probably will not happen. This is not to scare you. I only want you to make good decisions, and that involves knowing what the dangers are, even if they are unlikely.

Suppose you buy a house for $350,000 and you pay $50,000 out of your own money and borrow the rest ($300,000) from a bank at an interest rate of 5% per year. The amount you have borrowed ($300,000) is called the principal. If you paid the bank $15,000 a year (nearly $300 a week) you would only be paying the interest, and so the amount you owe the bank would stay at $300,000. (Paying only interest is what is known as an Interest Only Loan but it is usually only done for a few years and then more money is paid to the bank to start lessening the amount you still owe the bank.) If the $15,000 a year were all that you ever paid, however, you would have to pay the bank $15,000 a year, not for 20 or 30 years but forever, and when you can no longer pay that much, the bank would end up taking your house from you and selling it.

If the bank could sell the house for what you bought it for ($350,000), they would take $300,000 to pay back what you owe them and you would be given the extra $50,000 (but out of that money the bank would take other fees that might be as high as a few thousand dollars).

When the house is sold, however, and especially if you have had the house for many years, house prices will probably be higher than when you bought your house. If so, you will get back more than the $50,000 you originally paid out of your own money. However, although house prices usually go up over time, it is not certain that this will happen. In many parts of America, for instance, house prices fell by large amounts from 2006 to 2012. Many people could not keep paying their home loans and lost everything and had to try to find a place they could rent. Furthermore, because so many people lost their houses and were forced to rent, the cost of rent increased a lot.

This does not necessarily mean that it is better to rent than to borrow money to buy a house. If you had been renting a house and could no longer afford rent, you would, of course, also lose the house. In some situations, however, renting is better than trying to buy.

In order to avoid having to pay the bank forever, you will need to pay the bank not just the interest you owe them each year but as much extra as you can so that you begin paying off the amount of the loan. The smaller the loan gets, the less interest you will have to pay. In our example, the interest payment on $300,000 was $300 a week, but when extra money has been paid and the amount owed is lowered to $200,000, the interest is only $200 a week, and when the amount owed is only $100,000, the interest is just $100 a week.

Suppose you had a 20 year loan at an interest rate of 5% per year. That’s $50 a year for every $1,000 that you owe. If you paid the bank an extra $1,000 at the end of the first year of the 20 year loan, you would no longer have to pay any interest on that money. You would therefore have saved yourself 19 years of having to pay $50 a year. That’s a total of $950 saved. If, instead, you paid that money when you were half way through your loan, you would have saved only half as much interest. If you paid the $1,000 when you had only one year left, you would have saved yourself only one year’s interest – just $50.

So the best time to pay the bank extra money (the time when you will save the most money) is in the early years of the loan. This is the very time when you might want to buy such things as furniture for the house, but the more you can delay any expenses (perhaps even delaying having children) and use that money to pay off the loan, the less the total amount of money you will end up having to pay the bank.

Although the interest on home loans is a problem, the interest on credit cards or other types of loans (such as a car loan) is usually much higher. So it is even more important to avoid these other types of debt than lowering your home loan debt. To avoid these other debts you need to keep money available to pay off unexpected expenses.

Another important thing to consider, however, is that interest rates will change as the years go by. In Australia (I’m told it is different in America) a fixed rate loan means the interest rate will stay at that amount for a few years but after that fairly short time (one to five years), interest rates could go up or down by quite a lot. (With some loans you are allowed to get another fixed rate later, but again it will be fixed for only a few years and it might be fixed at a different interest rate to what it was the first time.) The reason why the interest rate is rarely fixed for more than a few years is that no one– not the banks, not the government, no one but God – knows what the interest rates will be in the future.

A variable rate loan means the interest rate could start changing almost immediately. If you have such a loan and the interest rate goes down, it is obviously good news, but if the rate goes up a lot, you might find yourself unable to keep paying the bank the higher interest rates. If so, you could be in danger of losing your house.

It is certainly possible for interest rates to go down, but interest rates are at present unusually low. Unfortunately, this makes it more likely that over time they will increase rather than decrease. (But no one can be certain.) The standard home loan in Australia in August 2013 was only 5.5% (five and a half percent) but at the end of 2008 it was almost 10% (9.45%) and in early 1990 it was 17% (Source). Using such numbers on a loan of $300,000 we get:

Year             Cost of Interest on $300,000

2013             $16,500 a year

2008             $28,350 a year

1990             $51,000 a year

1985             $39,000 a year

1980             $30,000 a year

1975             $30,000 a year

1970             $21,750 a year

1975             $16,140 a year

Hopefully, such a high figure as 17% interest will not happen again but no one can know for sure. If interest rates change, they are likely to do so a little at a time but the sooner you lower the amount you still owe the bank, the safer you are. Even if interest rates were to go down, the faster you pay off your loan the less you will end up having to pay the bank.

Let’s return to our example of a $300,000 loan at 5% interest per year. If you pay the bank $400 a week, you will end up having to pay a total of $570,000 (that’s $300,000 plus all the interest). If, however, you pay just $20 more each week, you will end up saving a little over $25,000. If, instead of an extra $20 a week, you paid another $5 (making $425 a week) you will end up saving a little over $30,400, so that instead of having to pay a total of $570,000, you only have to pay $539,600. (See Details for the exact numbers and how to work out your own numbers.) This assumes the interest rate does not change over the period of the loan. If the interest rate increases, your savings will be much more. It also assumes that you have a home loan that lets you pay extra without being penalized by extra fees.

If you cannot keep paying the bank because, for example, you get too sick to work, the bank might be kind and let you pay them less for a while. If you stay sick for a long time, however, and you cannot pay the bank what they ask you to pay, they could force the sale of your house and from the sale price take all the money that you still owe them. The same could happen if, for example, your husband or wife dies and so you lose what he or she would normally pay the bank. One way to help protect yourself from this risk is to get insurance. For example, you could pay an insurance company a certain amount of money each week so that if your husband or wife dies, the insurance company gives you a large amount of money you could use to pay off your house loan. This is called life insurance and sometimes banks insist that you have it or they will not give you a loan. You might even have some life insurance and not realize it. Another way that you might have life insurance is that the company you work for might pay superannuation for you and part of this might mean that if you died, money would be paid to your marriage partner or children. If in doubt, ask your boss. Another type of insurance is income protection insurance. This means that if you get sick and can no longer work, the company will pay you a certain amount of money until you are well again. There is also mortgage protection insurance. This means that if, due to sickness or injury, you cannot pay what the bank wants, the insurance company will pay it until you get well again, and if you die, your home loan is paid in full. If, however, you lose your job for some reason other than your health, the insurance company will not pay what you owe the bank. Lender’s mortgage insurance, however, is very different to mortgage protection insurance. Lender’s mortgage insurance protects the lender (the bank), not you.

I have mentioned the difference between fixed interest loans and variable rate loans and interest only loans, but there are many more differences between loans, depending on which bank or other lending place you use. They usually have different rules, different interest rates, different fees, and so on. Some might not even let you pay off the loan quicker than the previously agreed rate, unless you pay high additional fees. Also some will not let you change to another type of home loan without having to pay high additional fees. Loans that stop you from changing things without having to pay extra fees could end up costing you a lot of money. So you need to be very careful in choosing a loan. The best loan is not necessarily the one with the lowest interest rate and the loan that is best for one person will not always be best for someone else.

Finally, I should mention mortgage brokers. No bank or other place that lends money for houses is likely to tell you if you can get a better loan elsewhere. Mortgage brokers, however, can give advice about the home loans offered by quite a few (though probably not all) different banks and lending places. A mortgage broker can explain the differing rules, fees and so on and help you decide which best suits you. Because they are not working for just one lending place, they are more likely to be fair in the advice they give, but they are still doing this to earn money and sometimes they might make more money by trying to talk you into one loan rather than another. At least one well-known mortgage broker company in Australia is now owned by a certain bank. This must increase the temptation to get people to use this bank, although they claim not to give in to this temptation. Another consideration is that mortgage brokers might differ as to which (and how many) lending places they compare.

Since your choice of home loan could save you thousands of dollars, seeking advice from a mortgage broker seems a good idea. It might even be safest to see at least two completely different ones (working for different companies) to compare what they say.