How a Mortgage Works

Most people only understand that a mortgage, or home loan, is just the way of acquiring a home. No one really understands how it works in much detail so here it is broken down.

Bank needs money to lend money

The bank acquires money by borrowing it at a discounted rate. This is usually done through a number of ways like:

providing savings accounts or term deposits to the public

borrowing large volumes of money from overseas institutions

using a percentage of their profits

Lets use the example of the bank paying 3%pa for the above money they have borrowed. Now they need to make a profit.

Bank on-lends money to you

Now that the bank has all this debt it needs to on-lend this money to you in order to make a profit. The safest asset that a bank lends against is a property, which is why they usually make a small amount of profit because it is a safe investment for them with little risk.

Lets continue with the example we used before and say that current home loan interest rates are 5%pa. In this way you pay the bank 5% and then they pay their loan of 3% which leaves them with a profit of 2% pa

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Bank risk and your application

The bank's biggest risk is that you do not pay them their interest. As you can tell if you do not make payment to them they still have a debt they need to pay. If this was happening on most of their home loans the bank would very quickly make a loss and go out of business. So how does the bank manage this risk? The answer is your home loan application.

An application is a complete snapshot of your financial position including employment, assets, liabilities and most importantly your conduct with paying debts (also known as a credit file). If you have an application that shows bad conduct in paying debts the bank will look at you as a risk and very often decline your loan application. However if you show good conduct in paying debts the bank will be very comfortable with you as a "risk". Moral of the story here is make sure you pay your debts.

What do you need to get a home loan

A good way to sum up what we have learned is to show you what boxes you need ticked for a successful home loan application:

Savings (bank likes to see your ability to save money)

Stable employment (bank loves pay slips)

Clean credit! (pay your debtors on time)

If you can provide the following things then you are almost guaranteed to get your home loan.