Structuring Your Investment Loans [The Activate Way, Part 4]

Thursday, April 21, 2016 / Property Finance, Property Investment, Services

When you have made your mind up on an investment opportunity, it is time to ensure that you have the capital behind you.

What you may not be aware of, is that Activate Property grew from a company called Activate Finance.

In the early days our business was firmly structured around providing mortgage brokering services, and other financial products.

Our keen interest in optimising the implementation of Investment Loans was actually the initial underpinnings of what went on to create the investment property branch.

The first and foremost thing that you need to keep in mind when it comes to an investment loan for property, is that it is not the same as gaining a Mortgage on an Owner Occupied property. 

Investment lending comes under separate policy positions from within the banks and lending organisations as the strategies for successful investment lending can be more complex and strategic.

The First Difference Between Investment Loans and Home Loans

Right from the word go, you need to be prepared for an interest rate that is higher than your home loan’s rate.

For the record, this is not always the case. Occasionally major lenders will have a special offer available for investment loans, or other market factors will create a more competitive field allowing for lower interest rates.

This discrepancy was common in the market right up until the mid to late 1990’s, yet was less pronounced more recently.

The main factor that has caused this gap between owner occupied loans and investment loans, is the fact that the Australian Prudential Regulation Authority has demanded that investment property loan growth must slow to less than 10% a year.

The secondary factor that may cause a higher interest rate to be applicable on an investment loan, is that a Bank or lender may view the loan as inherently higher risk than a home loan.

One of the reasons this risk may be increased is due to the fact that an investor is often reliant upon forces outside of their control, such as rental markets and tenants.

Another Common Difference Between Investment Loans and Home Loans

The likelihood that an investment loan will be partly guaranteed by equity in a secondary property is higher. Many investors, in particular first time investors, will use the equity in their existing home in order to start their investment property portfolio.

Using equity can be a great method of getting a leg up into building your investment property portfolio.

We thought we would take a moment aside to describe the two most common ways of generating equity in your existing home.

Organic Equity

This is the natural equity that has grown simply due to the fact that the value of your own home has grown. If you have been in your home for 10 years, then it is quite likely that the value of your home will have grown significantly in that time.

For example:

If you bought a home in Trott Park, SA, 5158 in 2007; the median price you would have paid is $254,000

The median price for a home in Trott Park, SA, 5158 in 2016 is now $340,000

Now, you could choose to sell this property and potentially realize an $86,000 capital gain.

Or

You could choose to stay living in the house (it is home after all) and instead access the equity that has been produced.

The production of equity in this scenario is a by product of the value growth in the suburb.

 

Manufactured Equity

Manufactured equity is the equity that you create every single time you make a mortgage repayment that also pays off a small piece of the principal loan amount. This obviously does not apply if your repayments are being managed on a interest only loan, however it is rather uncommon for someone to have their owner occupied home on an interest only loan. Interest only loans are frequently used by investors as a means to control the cost of holding a property, among other reasons.

Over the period that you have been living in your home and paying off the principal of the mortgage, you are creating equity through your repayments.

If we take the Trott Park scenario once again, we can see that the median price for a home was $254,000.

We also know, thanks to data from the RBA that the standard variable home rate in 2007 was 7.55% PA for the first half of the year, and 8.05% PA for the second half of the year.

The standard variable rate dips up and down over the last 10 years, but the average (in this case, calculated as the mean average) across the last 10 years is 6.85%

If we run this through a home loan repayment calculator and set it to a standard 30 year mortgage with monthly repayments, we can see that after 10 years the principal that is paid off is $36,812 and the loan balance is $217,188

Now, when we look at the example in Trott Park, we can see that:

The market growth has generated $86,000 in organic equity

The principal repayments over a ten year period have manufactured $36,812 in equity.

Leaving a total equity of $122,812 

This equity can then be used to assist in the purchase of an investment property.

Using this equity is still not a simple process, and has some hidden pitfalls if you do not do your research.

Such as:

Cross Collateralization of Your Home and Your Investment Property

Whilst the word may seem overtly complicated, the premise is simple.

You guarantee your investment loan by promising that if everything takes a major turn for the worst, that your owner occupied home may may be sold in order to recover the loan costs.

Equity is taken out of your owner occupied home, and then used to assist in buying the investment property by securing your investment loan with both your owner occupied property and also your new investment property.

Many property investors may not even know if their investment loan has been cross collateralized, and may actually need to check the body of the contract for their investment loan and see which addresses the lender holds or will register its mortgage over.

Problems with Cross Collateralization

The biggest problem may be that the investor is potentially placing their own home in which they live at risk. In this scenario, should the investment turn bad, the lender has the legal right to require both the investment property and the owner occupied to be sold.

Another significant problem that is caused by cross collateralization is that it places a larger degree of power within the hands of the lenders. By giving them a stronger position over the portfolio, they are able to dictate more of their own terms as to how the funds received from selling off properties is allocated.

Cross collateralization loans are also more complex in the way they are drawn up and contracted, which can make them more expensive regarding fees, as well as limiting the product choices that can be made.

Lastly, cross collateralization can eventuate in hitting a ‘debt ceiling’. Regardless of how well and how stable your portfolio is going, a lender who has full control over the finance of a cross collateralized portfolio, may simply decide that it is time to cease lending to you. This can put the breaks on your property portfolio rather quickly.

How Can You Avoid Cross Collateralization?

An experienced investment mortgage broker will play a vital role in structuring your investment loan in such a way that you are not putting your owner occupied home on the collateral list for your investment property, as well as making sure that you maintain control of your property portfolio.

This is a process of setting up your finances in such a way that you maximise your own control, minimise any costs that can not be claimed on tax, ensure that your owner occupied is not on the title of your investment property, and help make sure that you don’t get locked up in any debt ceilings.

The process involves setting up a series of loans, as seen below. Once again, from the scenario that the Trott Park home owner decides to buy an investment property worth $340,000 with their equity (and no cash upfront at all).

This process of gaining the investment loan is essentially a process of setting up 2 additional loans.

There is the initial loan on the owner occupied home, we will call this Loan 1.

There is an additional loan, drawn from the equity of the owner occupied home, we will call this Loan 2.

Then there is the investment loan, used to purchase 90% of the investment property, we will call this Loan 3.

Using this 3 loan structure, we will be able to finance the investment property with no cash up front, whilst at the same time, ensure that there is no cross collateralization.

Notes on Each Loan:

Loan 1*

This is the original loan for the owner occupied property.

Amount Owed: $217,188

Purpose of the Loan: To purchase a home to live in

Collateral: The original owner occupied home

Payment Arrangement: This would typically be set up as an interest + principle payment

Lenders Mortgage Insurance Applicable: As the total amount owed for the property is less than 80%, there is no applicable LMI

Tax Deductible Status: No parts of this loan would be tax deductible

 

Loan 2**:

Amount Owed: $54,000

Purpose of the Loan: To pay the deposit on the investment property

Collateral: The original owner occupied home

Payment Arrangement: This would typically be set up as an interest only loan

Lenders Mortgage Insurance Applicable: As the total amount owed for the property is less than 80%, there is no applicable LMI

Tax Deductible Status: As the purpose of this loan was to assist in buying investment property, the interest on this loan is tax deductible

Monthly Repayments (based on 4.82% ): $216.90

Loan 3***:

Amount Owed: $306,000

Purpose of the loan: To purchase an investment property

Collateral: The investment property

Payment Arrangement: This would typically be set up as an interest only loan

Lenders Mortgage Insurance: As this loan comprises more than 80% of the property’s value, LMI would be applicable. The LMI in this situation is also tax deductible.

Monthly Repayments (based on 4.82% ): $1,229.10

 

 

Total Monthly Repayments Required To Maintain Loans for the Investment Property: $1,446

 

 

Additional notes on Lenders Mortgage Insurance (LMI)

In this scenario, we have accessed the equity of the owner occupied home, yet made sure that we kept the total amount borrowed below 80%.

If the total borrowed on the owner occupied home exceeded 80% then Mortgage Lender’s Insurance, or LMI would need to be paid.

Not only would LMI be applicable to Loan 2, it would also be applicable to Loan 1; as they are holding the same property as collateral.

Furthermore, the LMI paid on an owner occupied property would not be tax deductible.

Additional Notes on Loan 2

Loan 2 comprises a $54,000 loan, which covers the 10% deposit for the investment property, as well as budgeting for $20,000 in fees and stamp duty.

(Note, you may have selected a property in your strategy sessions which has stamp duty concessions, which would mean we could structure this entire loan process differently and potentially avoid LMI on both properties!)

With Loan 2 covering the fees and the deposit for the investment property, the last 90% of the property is funded by Loan 3, which is an investment loan.

 

 

When it comes time to arrange the finance for your investment property you want to make sure you are working with a seasoned broker that knows the industry inside and out. It can be all too easy for a large lender, or a burn and churn broker, to set up a simple cross collateralised investment loan and be done with it.

Activate Finance is committed to making sure that we investigate all options in our attempt to bring you the best possible financial products and services!

 

Check out the next article outlining the activate way, and learn what the next step is in our process of helping our clients build wealth through property investment. See part 5 of the activate way here.