A common question asked by inexperienced investors is:
“How much should I borrow when purchasing an investment property?”
The general consensus will usually advise investors to borrow no more than 80% of a property’s purchase price. Why do they advise this? Simple, because when borrowing 80% or less the investor is not required to pay for Lenders Mortgage Insurance (LMI), which can be pretty expensive. However, if for argument sake we say the goal of an investor is to create a strong portfolio to build wealth, would it then be more beneficial to borrow over 80% and increase their risk within the property market? And how big are the costs associated with an LMI?
Both are valid questions and will be discussed at length in this article.
How does LMI work and how much does it cost?
An LMI is a contract setup by the lender when a borrower takes out a loan of more than 80% of the property’s value. Typically a lender will use a third party insurance company to setup the deal, with the two biggest players in Australia being PMI Mortgage Insurance and GE Mortgage Insurance.
An LMI is set in place to insure the lender not the borrower in case the property does not yield more than the loan amount owed when it’s sold after repossession. If a borrower happens to default on their loan and the property is repossessed by the lender, this is when an LMI may come into action. The lender will sell the property in order to cover the outstanding debt left by the borrower. However, sometimes (although very rare) the sale of the property does not cover the outstanding loan and lenders end up with a loss. By having an LMI in place lenders avoid losses by claiming whenever they make a loss. Current data reveals that less than 0.12% of LMI agreements have been paid out, showing that in reality the situation above rarely happens.
Lenders only opt for an LMI when handing out loans greater than 80% of the property’s value because they impose a much greater risk. Premiums worked out on an LMI are calculated using the base percentage against the total loan amount. The higher the loan-to-value ratio (LVR) the greater the premium, with rates between lenders varying drastically. By shopping around a borrower can save as much as $2,000 on a loan size of $600,000.
Working out the cost of an LMI – To do this multiply the total loan amount by the lender’s premium percentage, then add stamp duty which will vary depending on state. To paint a clearer picture, Bob is wanting to purchase a property in Melbourne, it’s valued at $500,000 and he wishes to lend 95% from his lender ($475,000). The cost of the LMI is as follows:
Total amount borrowed x premium percentage x Stamp duty (10% in Queensland) = LMI cost
$475,000 x 2% x (1 + 10%) = $10,450
The LMI costs can sometimes be added to the overall loan amount and is known in the industry as capitalising LMI, which means the borrower is now loaning 97% of the property’s value. Capitalising LMI is becoming common practice and more lenders are changing their policies to allow borrowers to do this.
Note: Loans that are paid within a short period of time (usually 1-2 years) can sometimes get a partial refund on their LMI. Borrowers must ask their lender to include this in their package otherwise it won’t be offered.
Applications that require LMI’s will be checked by both the lender and the mortgage insurer. Mortgage insurers checks are more authoritarian and take the borrower’s employment, income level and property location into account. Depending on the lender, some can auto approve on behalf of their mortgage insurer.
It’s possible to lend more than 80% (but less than 85%) without needing to apply for an LMI. To be eligible for this most lenders will implement a faster repayment scheme to reduce the LVR to 80% within a few years. Lenders will not put this on the table openly, so please ask.
Loans amounts split up into two groups, they are:
- Loans under $500,000
- Loans over $500,000
For loans that are under $500,000 most lenders and mortgage insurers will limit the borrower’s loan to 95% of a property’s value. Loans over that threshold are usually capped at 90% and then 85% for loans greater than $750,000. Loans in the range of $750,000- $1 million are decided on a case-by-case basis, and it’s extremely difficult to get approved for loans over $1 million.
Look around longer enough and borrowers can find local lenders who will allow them to lend as much as 100% of the property’s value. In this casen the borrower must occupy the property, with the property being located in a major urban area and the loan size ranging between $500,000-$600,000. Interest rates on these loans would be very similar to a standard variable (give or take 0.50%), if the borrower is happy to pay a higher interest rate (9-9.5%) they can borrow as much as $750,000.
Note: A 100% LVR is not easy to secure and the borrower must be considered ‘desirable’. A desirable candidate would be someone with a stable income, solid employment history and good credit.
Our prediction is that 100% loans will be cropping up a lot more in the coming years, particularly for high-income professionals living in major cities who have been leading lavish lifestyles. Soon they will realise that a down payment of at least $60,000 will be needed to get their foot on the property ladder, and borrowing 100% will be the most cost effective way to do this.
LMI – Is it tax deductible?
Taking out an LMI is considered to be a borrowing cost, meaning investors can use it for tax deductible purposes over a period of 5 years. Investors who manage to fully repay or refinance their loan within the 5 year time frame they are allowed to claim the leftover amount as a deduction. For example, if mortgage insurance that cost the investor $6,000, they can make a claim each year for $1,200 for a total of the 5 years.
Note: We always advise to get professional independent advice from an expert in this area.
Should we borrow more or less than 80%?
Let’s find out with our good friend Bob helping us. Bob has just begun his investment career and currently has one property, his home. Bob’s home is worth $400,000 and has $270,000 left on his mortgage. Bob has the following options:
Option 1- Borrow 80% or less
Bob can go ahead and increase his home loan to 80% of his home’s value to $320,000. This will give Bob $50,000 ($320,000 – $270,000) to use to place a 20% or more deposit on a new investment property worth a maximum of $200,000.
Purchase price: $200,000
Cost (stamp duty etc): $10,000
Loan amount: $160,000
Option 2 – Borrow more than 80%
Bob decides to increase his existing loan to 90% of the value of his home. This move will give Bob $90,000 to put forward towards his next property. The property he is looking at is valued at $500,000, his costs would be:
Purchase price: $500,000
Cost (stamp duty etc): $25,000
Overall loan: $447,50
Note: The LVR does not include the LMI loan.
Going on the assumption that both properties in both options are equal in all aspects including capital growth and rental yield, with a capital growth of 5% each year, which option is better for Bob?
|Property Price||Estimated value in 5 years||Property equity|
Conclusion: Figure 1.0 shows us that it’s much better for investors go with the LMI option as they will gain $83,000 more in equity after 5 years from a capital growth point of view based on our scenario.
In the next example we will see how cash flow is affected when investors opt to borrow more than 80% over the same 5-year time-span.
|Costs||Option 1 (80% Loan)||Option 2 (90% loan)|
|Cash flow deficit||$26,900||$71,525|
|Net cash deficit||$13,900||$30,775|
Conclusion: Investors will profit by $60,125 over 5 years based on our assumptions in figure 1.1 if they borrower a higher amount on their loan. While the cash flow deficit is not amazing at only $17,000 based over 5 years, the major consideration is the huge increase in capital growth.
In both examples, it clearly displays that investors would be far better off lending more than 80% as this will provide them with the greatest returns. As a result, 100% loans are becoming an increasingly common option for investors. Such products provide investors the chance to leverage their assets more effectively while minimising costs. In most cases the investor will pay around 2.5% for their mortgage insurance, adding in other costs such as stamp duty and it’s around 3-5%. This allows them to purchase as much as 300% more by opting to go with a 100% loan as appose to fronting 20% of their own money to avoid an LMI.
Taking out a 100% loan provides investors with other benefits too, they include:
- Greater choice in property options, they can now buy in better areas that offer high capital growth returns.
- Purchasing a better home in a more desirable area reduces the amount of time the property is left vacant.
- Being able to purchase two properties instead of one and diversifying risk.
The risk factor
Investors shouldn’t think that choosing a 100% loan is risk-free, the more money that is borrowed the more the investor has to lose. Investors need to weigh up several ‘what if’ scenarios and be sure they have a solid plan in place if things don’t go as expected. If interest rates increase, capital growth remains static or the property stays vacant for longer than intended, investors need to plan for every possibility to not be caught out.
Being able to meet the monthly repayments is extremely imperative going down this route, as it can yield amazing rewards if the capital growth goes the way the investor expected. On the flip side, anyone who thinks they will struggle to make payments and if problems arise will be required to sell a property, there’s a high probability of making a loss due to all the costs associated.
Think long term
Most see an LMI as an expense that can be easily avoided and they do exactly that. While they are right, paying a little bit extra now can yield a much greater return further down the line depending on investor goals. Before totally rejecting the idea of paying for an LMI, do the following research to see if you would be better off with it, or without it:
- Crunch numbers like we did above and see which options yields greater returns.
- Think about the possible tax deductions available with an LMI.
- List down the pros and cons of choosing to purchase a higher value property.
- Understand the higher the loan amount the fewer lenders there will be.
- Research the costs of LMI between various lenders.
- Understand all the risk associated with taking out bigger loans.
This article is not advising anyone to take out a property loan for the maximum amount possible, but showing a strategy that can be extremely beneficial to certain property investors. One must consider their own risk appetite, goals and financial situation before they decide what they can handle.
Getting your pre-approval
For investors who think they are viable candidates to implement the strategy mentioned, we advise getting a pre-approval before doing anything else. Doing the legwork now can save a lot of paperwork, hassle and stress. Most pre-approvals are free to do and can vastly simply the approval process later.