Financing an investment property.

Hi, thanks for watching our video on ‘Financing an investment property’. This is the 2nd video in our 3-part series. The first video ‘Investing in property’ explored things such as ‘why invest in property’, the different strategies you might employ, and some of the risks involved with investing in property. This video looks at financing an investment property purchase. Getting the cost and structure of your finance right is one of the key elements of successful property investing.

Before I get started, I need to let you know that the information contained in this presentation is general in nature and has been prepared without taking your objectives, needs and overall financial situation into account. For this reason, you should consider the appropriateness of the information to your own circumstances and, if necessary, seek appropriate professional advice.

One of the keys to successful investing lies in understanding what you are looking to achieve from the investment, or what your strategy is. Are you looking for capital growth, cash flow, or a combination of the two? This strategy will also have a big influence on how you finance an investment property and help answer questions such as ‘How much finance?’, ‘What type of finance?’ and so on.

So, in terms of financing an investment property, we’re going to start by identifying how much money is required, then consider where it will come from. Firstly, of course, there is the price we will pay for the property, however there are quite a number of other additional costs that need to be accounted for as well. Then, in terms of where the money will come from, we have a couple of sources.

You will need to have your own savings or contribution, and for most people they will require a home loan.

The purchase price is fairly self-explanatory, but let’s have a look at what some of the other costs are. There are a range of other costs that you’ll need to factor in – all of which will impact your affordability.

Stamp duty is potentially the biggest additional cost. Stamp duty is collected by state governments and is calculated based on the purchase price of the property. The rate differs from state to state. Your legal representative will tell you the amount required or you can find the information online from your state government website. Be aware that these stamp duty costs can be in the 10s of thousands of dollars.

Other government fees include registration fees for changes to the Land Titles register. Again, these differ from state to state but your legal rep or lender will be able to give you the specific information. Your solicitor/conveyancer will charge for their time and recover any costs they incur, such as property searches. It’s advisable to have at least a building inspection, if not a pest inspection as well, and of course the relevant inspectors will charge for their services.

Your lender may have a loan application fee, and you may require Lender’s Mortgage Insurance or LMI. I’ll talk more about that soon. In some states it’s also important that when you sign a contract on the property, you insure the property. As soon as you have signed the contract you have a financial interest in that property. Your lender will most likely require this prior to settlement too.

Then you may have some renovations or improvements you wish to make prior to getting a tenant in the property. Take care that any improvements you do are actually improving your yield from the property too. I highly recommend researching each of these costs and factoring them into your planning.

Next we’ll explore your contribution, which can come from a number of sources. To illustrate we’re going to use an example of purchasing a property worth $540,000. Lenders will generally lend up to 80% of the market value of the property, meaning that the purchaser needs to contribute at least 20% plus cover the upfront costs we just discussed.

So, in this scenario that means the lender could lend up to $432,000 (based on the property value) and the purchaser needs to provide a deposit of $108,000 … plus cover the upfront costs that we have estimated in this case to be $22,000. Meaning the total contribution by the purchaser would be $130,000.

Saving that deposit is often one of the biggest challenges for any intending home buyer. The good news is there are some alternatives that you may be able to use. Now, if you’re already paying off another home you could potentially use the equity you’ve built up in an existing property as an alternative to a cash deposit.

So, let’s say you have an existing property worth $500,000. Applying the 80% LVR means his property has a lending value of $400,000. The difference between the lending value and existing loan balance is equity. So, let’s say in this case that the existing loan has a balance of $290,000 leaving $110,000 in equity that could be used in lieu of a deposit to purchase an investment property. This works by linking the security (that is, your mortgage) over the existing property to the new home too.

Another alternative is to use lender’s mortgage insurance or LMI. LMI is used where less than 20% of the value of the property being purchased is available as a deposit. It’s an insurance that covers the lender in the event of a loan default by the borrower. The cost though is borne by the borrower. So “why would I pay for insurance for the bank?” you might ask. There are a couple of good reasons why you might choose to have a smaller deposit and incur the LMI cost.

Firstly, it can help new investors get into the market with a lower deposit. Relating this back to the example we have been using… let’s say you’ve only been able to save a deposit of $54,000. Either you would only be able to purchase an inferior property worth $270,000 or using LMI the lender may be able to lend to a higher % of the property value. This of course is dependent on you being able to afford the higher loan repayments as well.

Secondly, it may allow the purchase of a higher priced property than you may otherwise be able to afford. Let’s say your $108,000 is now a 10% deposit. With LMI providing a 90% LVR, this may allow you to purchase a property worth $1,080,000. This of course is dependent on you being able to afford the higher loan repayments and interest on a larger debt.

LMI does significantly increase the up-front costs, but it may be worth the extra money to take the opportunity to purchase a better property that will potentially provide better returns in the long run. So that’s some alternatives for your contribution, but now let’s delve into some of the ins and outs of getting a home loan for your investment property purchase.

So, the first question on many people’s lips is ‘How much can I borrow?’ In general, how much you can borrow is dependent on 2 things. Firstly, how much the property is worth; and secondly, how much you can afford to repay. We’ve already had a look at how much lenders may be able to lend depending on the value of the property, but this is only one half of the equation. Let’s now drill down into repayments and affordability.

In assessing an applicant’s capacity to repay finance, the lender will consider all the household income including the rent that will be received on the new investment property; what other commitments need to be met, for example other loan repayments or phone payment plans; and regular household expenses.

They’ll also examine the spending patterns and behaviours of those reliant on the household income – this includes things like regular use of facilities like ZipPay or AfterPay, regular contributions to betting accounts, or even using multiple streaming services. Based on the number of people in the household, and the family makeup there is a minimum surplus that households need to have. Lenders are also required to build in a buffer to accommodate interest rate increases.

All this information also needs supporting documentation to verify it. Things like payslips, bank statements, superannuation statements and so on. This brings us to the next question around affordability - of how the repayments will be structured.

There are 2 common repayment structures: Firstly, Principle, Interest, and Fees PIF) is probably the one most people are familiar with. This type of repayment includes a reduction to the principle amount of the loan as well as covering accrued interest and fees. By reducing the principle amount of the loan, assuming the property value doesn’t decrease, then equity in the property is increased. This type of repayment structure supports a long-term strategy to grow equity.

PIF repayments are often structured on a monthly basis however equity can be improved more quickly by making the repayments on a fortnightly or weekly basis. Because the loan principle is being decreased sooner, less interest accrues. Over time this can make a significant difference. There are a number of online calculators available that can calculate the savings for you.

This is discussed further in the video ‘Measuring returns on an investment property’ where we are exploring ways to maximise the return on an investment property.

The other type of payment is Interest Only, where payments only cover interest accrued and fees, usually on a monthly basis. The loan principle remains the same for the Interest Only period. This type of payment is often used when an investor is relying on capital growth of a property or wishes to keep costs to a minimum to suit their cash flow situation.

This option is often only available for 1-5 years with the loan then converting to PIF repayments over the remaining term. Some lenders charge a higher interest rate for this repayment structure as it is riskier for them. This, in addition to the principle amount not reducing during the interest only term, means that with this repayment structure you will usually pay more interest over the term of the loan.

By way of illustration, let’s say we have a $500,000 loan being repaid over 25 years with an interest rate of 5%pa. Assuming there are no changes over the life of the loan then the PIF repayments would be $2,923 a month over the 25 years and total interest of $376,885 would be paid over that time.

On the other hand, if the repayments were structured as Interest Only over the first 5 years, then switched to Principle, Interest and Fees over the remaining 20 years, then for the first 5 years the interest only payments each month would be roughly $2,100. The PIF repayments would then increase to $3,300 for the remaining term. In total $416,947 would be paid in interest. That’s an additional $40,000 over the life of the loan.

The repayment structure you select will depend on your investment strategy for the property and the expected income from the property. Another important aspect of your loan is whether your interest rate is fixed or variable.

As their names suggest variable rates will fluctuate over time. Fixed rates on the other hand, are fixed for a specified period of time. This has the effect that repayments are also fixed for that period of time, making it easier to budget and manage your cash flow. However, because your rate and repayments are set at a specific level you are generally not able to make higher repayments than those agreed without incurring a penalty.

Locking into a fixed rate also means that if the variable rate falls then you don’t get the advantage of the reduced rate. Variable rates on the other hand, while it may mean that your repayments can increase or decrease, because you are not locked into a set repayment amount, as long as you pay the minimum required you can set your repayments to suit your situation – making extra repayments when you have the money available.

To illustrate fixed versus variable interest rates let’s take our $500,000 loan over a term of 25 years but go back in time to a period of fluctuating interest rates. At this time, if we kept our whole loan as variable for the first 5 years our repayments would have started just under $3,600 per month, soared to almost $4,400 per month and dropped to almost $3,200 per month.

However, if we had fixed the interest rate for 5 years our repayments would have remained at around $3,500 every month for the 5 years.

For this 5-year period, fixing the interest rate would mean we saved some money on our loan. However, if we fixed for the next 5 years, when the variable rate dropped, we would have saved more money by being variable. For the last 5 years it looks like fixed may have been slightly better than variable. Nobody knows for sure what future interest rates will be, they are dependent on what is happening in the economy and world financial markets.

In a bid to take advantage of the best of both worlds it is not uncommon to see people splitting their loans into a variable and a fixed portion, providing both repayment certainty and a level of flexibility that can be tailored to suit your personal situation and goals.

As an example, let’s say we have a $400,000 home loan. This could be split into 2 loans of $200,000 – one fixed and one variable. We’d then be able to make extra repayments on the variable portion. However, on the fixed portion we can be certain both the rate and repayments won’t change during the fixed term.

Getting your finance structured in a way that suits your investing strategy is a large part of successfully investing in property. The 3 key things you need to consider carefully when financing an investment: • How much cash or equity will I contribute to the purchase? • How will I structure the repayments? Is Interest Only or PIF going to suit my purposes better? • Is a fixed rate or variable rate, or a mix of the 2, going to work best for my investment?

The costs of your finance on an investment property have a direct impact on the return you’ll achieve on the property, so I hope you’ll watch the video on ‘Measuring returns on an investment property’ too. As I just mentioned, we hope you’ll take the time to watch the other 2 videos on ‘Investing in property’ and ‘Measuring returns on an investment property’ as getting your finance correctly structured is one of the keys to achieving the returns you’re looking for from investing in property.

Thank you for watching our video on ‘Financing an investment property. I trust you found it helpful and I encourage you to check out the other resources on the Davidson Institute website to help build your financial confidence. Bye for now.