Thinking ahead and setting up a flexible structure is something overlooked by investors and their advisors. So many people jump into the deep way too fast and end up with cross-secured loans that cost thousands of dollars to get out of. This article will cover what a bad structure is, how to fix or avoid them in the first place, and other options investors should be thinking about when investing in property.
Fixing a bad structure
What is a bad structure? Well, a bad structure would involve anything that includes cross-securitisation and fails to separate debts and assets from one property to the next. Cross-securitisation is when a single property is secured by two or more properties, this causes problems as it hinders flexibility.
These structures are deemed ‘bad’ because it locks in the borrower, reducing their flexibility while providing the lender with more security than needed. In this scenario, the lender has no incentive to change the loan structure and the borrower cannot do much without paying severe costs to alter it. As a result, borrowers will find it very difficult to uncross-securitise their structure as the lender has nothing to gain from doing so.
The best way to fix a bad structure is by changing or splitting loans, this can be done very cheaply or sometimes for free when using a professional package.
Example of a restructure
Bob is a property investor and has two properties, one is his home and another is an investment property. Bob’s home is valued at $500,000 and his investment property at $300,000. Bob managed to secure his investment property by taking out a home loan for $100,000 along with another $210,000 loan for his investment property and costs. His investment loan is now secured by his home and the investment property, meaning it’s cross-secured.
Now, we need to fix this loan so that it’s split into two separate parts to give Bob more flexibility and options for the future. Part I of the loan should be the maximum amount needed to secure his investment property, this tends to be 80% of the property’s purchase price ($240,000). The remainder will be secured by Bob’s home.
Loan 1- $100,000 secured by Bob’s home
Loan 2- $210,000 secured by Bob’s home and investment property (cross-secured)
Loan 1- $100,000 secured by Bob’s home
Loan 2- $70,000 secured by Bob’s home
Loan 3- $140,000 secured by Bob’s investment property.
After the restructure, each loan is backed by a single property separating the assets more clearly.
Note: Loans that have been cross-secured with a fixed-rate interest may be much more difficult to restructure. Break costs are associated with all fixed-rate loans, meaning borrowers may have to wait until the loan agreement is over before changing.
Pros and cons
Most reputable lenders will provide professional packages which offer the borrower several features and special interest rate discounts. The biggest advantage of these products is the borrower can apply for several mortgages without having to pay application costs or ongoing fees. Opting for professional packages allow investors to setup the right structure every time assuming they have the knowledge on what not to do.
However, these packages are not ideal for everyone and sometimes one must weigh up the pros and cons of a professional package. To give an example, in order not to cross-securitisation a loan the borrower must take out two separate loans, this could mean the borrower pays twice for the application process and two monthly fees. In these situations going for a professional package may not be the best route as the costs involved would not be the most advantageous structure.
Creating a structure with mortgage insurance
Loans that are over 80% of a property’s value will require the borrower to purchase Lenders Mortgage Insurance (LMI) to cover the risk of the lender. The LMI amount will vary from loan to loan and is based on the loan-to-value ratio (LVR). Usually, the higher the LVR the higher the costs, but there are ways to minimise these costs by having a good structure.
|Extra money needed||$60,000
In Figure 1.0, Bob has two options, they are:
- Option 1 (figure 1.1) is to increase both loans to 85% of the property’s value, and then pay LMI on both loans.
- Option 2 (figure 1.2) is to increase one loan to 90% and increase the other loan to 80%, meaning Bob only pays LMI on one of the loans.
|Loans||Increased amount||LVR||Cost of LMI|
|Loans||Increased amount||LVR||Cost of LMI|
Bringing Bob back into the picture, this time he has two investment properties and wishes to borrow $60,000 to buy a third property. From looking at the data above the difference between Bob picking option 1 rather than option 2 will save him $750. It’s certainly important to do the math to see which options are most favourable when taking out loans for more than 80% of the property’s value.
The LMI cost will vary vastly from lender to lender as shown in the example, by picking a different lender it’s quite common to save as much as $2,000 or more. Here is when having a well planed structure can pay dividends, when investors are not tied down to a particular lender they can shop around and get the best deals. Some lenders offer a partial refund for borrowers who can reduce the LVR to 80% within 1-2 years, but they must ask for this as lenders won’t openly put it on the table.
The problems with fixed rates
Investors should approach with caution whenever they take out a fixed-rate loan, combined with a bad structure they can leave them high and dry in the future. Fixed-rate loans will in essence ‘freeze’ a structure in place for the duration of the agreement, as the break costs are usually so high that changing structures is not a viable option.
Unless an investor is 110% sure they will not increase their loan, sell the property or change their plans during the agreement, they should think twice about choosing a fixed-rate loan. A change in goals or a cash flow problem that was overlooked is sometimes all it takes for an investor to want to alter their plan.
For investors who are 110% sure they will not change their mind, our advice is this: ensure the fixed-rate loan is not cross-securitised, as this way costs associated with breaking the loan will be minimised.
Take the smart approach to selecting products
The more features a product has the greater the costs. For example, line of credit products offer investors much more flexibility and features, but come at a greater costs. Compared to a basic variable product which lacks in features but comes at a much lesser cost.
It’s quite possible to get the best of both worlds by taking out a small line of credit to use on a short-term basis (pay the 10% deposit), and then apply for a basic variable loan to pay the rest, which also includes repaying the 10% line of credit debt. Either way, investors need to think carefully about the products they buy and whether they are paying too much for features they never use.
Thinking about borrowing capacity
When planning for the future an investor should understand how the lender views them to figure out their borrowing capacity.
How lenders work it out – Most lenders treat external debts the same way as they do with internal debts. This means if Bob has a loan for $100,000 with another lender and pays an interest rate of 5% ($5,000 per year), most lenders will ignore this fact. Instead, they will use a benchmark rate that is usually 2% higher than the standard variable on an interest and principal basis. Meaning Bob’s $100,000 loan would equally to him paying back 8% ($8,000 per year).
This is not true for all lenders, some will actually go by the actual repayment amount ($6,000) than the example provided above. Although it doesn’t look like much in the grand scheme of things, this can actually make a huge difference and it’s betted suited for investors to pick a lender who doesn’t view internal and external debts as the same thing.
Once the investors has reach their borrowing capacity, they can then pick a lender who treats external debts differently to best maximise their borrowing capacity. Investors should not read this as a green light to exhaust their borrowing capacity with lenders but rather, to know this option is available should they need to borrow more money. Understanding and managing debt is a huge part of becoming a successful property investor, just because a lender is happy to provide money, doesn’t necessarily mean it should be taken.
This article has ignored any tax issues, legal or financial planning challenges that could arise as a result of creating or changing a structure. An experienced mortgage broker can sometimes dwell a bit of light on these areas but always talk to a professional within the industry to get the real hard facts. We suggest running any structures passed experts in the accounting field, lawyers and well respected financial planners to see how waterproof and legal the structures are. A bit legwork now can save huge fees and headaches in the future.