Finance for Beginner Investors
Firstly “What is Finance”?
Finance is basically obtaining the funds to purchase something. In this case it refers to borrowing the funds from a bank or lender to purchase an investment property.
Using Finance to purchase an asset that will increase in value or provide a cash income is called leverage. You are leveraging “other people’s money” to help build your own wealth.
I am sure you have read about people that build multimillion-dollar portfolios and asked yourself “How did they manage to borrow all that money”?
It almost seems impossible to the average person when most people are struggling to pay even one mortgage. The good news is that it is possible and that its not that difficult if you follow a few simple rules.
There are two types of beginner property investors.
- An investor that has never purchased a property before and has saved a deposit
- An investor that has an existing property and will use equity as a deposit
Both types of investors want to purchase an investment property though the approach for each scenario is different.
A mortgage broker that is also an investor and an expert at structuring property portfolios is vital for both types of beginner investors to achieve success.
Borrowing Capacity - What is it?
Before beginning to search for a property you will need to know how much you can borrow. This is called Borrowing Capacity (BC). Your BC is one of the most critical aspects to purchasing. How do you know your price range if you don’t know what a bank will lend you?
Your Borrowing Capacity is determined by two main aspects. Your income vs your amount of debt. It will also be affected by how many children you have and your living expenses per month.
Example A: A married couple with two children earning $80,000 each with one $10,000 credit card and a monthly living expenses of $4,300 may have a Borrowing Capacity of $500,000. That means a bank will lend them $500,000.
Example B: A couple with four children and earning $80,000 each with the same credit card limit and living expenses will have a smaller Borrowing Capacity of say $450,000.
More children, more debt and higher living expenses that are above average means lower Borrowing Capacity. Alternatively, higher income, less debt and average living expenses means an increased Borrowing Capacity.
Low income + Children + High Debt + High LE = Low BC
High income + Low Debt + Average LE = High BC
Now that we know how Borrowing Capacity is calculated we still don’t have all the pieces yet to set a price range for our property purchase.
Deposit
Deposit is the third piece of the puzzle. You may have a BC of 2 million dollars however with no deposit you cannot purchase a property. Your deposit amount is equally essential as your BC when finding your price range for the property you wish to buy.
A deposit can be in the form of savings, a cash gift from family, a family guarantor (using a portion of a family members property) or equity from another property that you own.
When you speak to your finance broker, they will calculate from your deposit amount what price range you can comfortably afford. And match that with you Borrowing Capacity. You may have a BC of $800,000 yet your deposit amount may only allow you to purchase a property worth $400,000.
Maximising your deposit can be a great way for investors to continue to build their portfolio. If you have $400,000 of deposit and purchased a $500,000 house it would not stand to reason to use your entire deposit. Splitting the$400,000 into smaller amounts to be used for deposits on multiple properties will allow you to continue building your portfolio and reach your investment goals.
Dispelling the 10% deposit notion
Getting a loan for an investment property is different than if you were buying an owner occupier property. The Bank wants you to have more skin in the game. Most banks will only lend up to 90% (LVR) Loan to Value Ratio including Lenders Mortgage Insurance (LMI).
This means that if you were to make a 10% deposit then when LMI is added (capitalised) onto your loan the total amount increases and so does you LVR pushing you over the 90% limit and meaning a decline on your application.
90% LVR + LMI = 91.6% LVR = No go for most lenders (two lenders will go to 95%)
To counter this, I recommend making a 12% deposit. This will keep you just under the 90% cut off when LMI is added and give you access to the majority of banks and lenders.
So, remember you will need a 12% deposit at least to be able to use most lenders and to give you a broader range of finance options when purchasing an investment property.
Back to our two types of Investors:
Investor 1 has a $60,000 deposit and a BC of $500,000. This investor is looking to purchase in NSW and as an investor don’t forget you will have to pay stamp duty. Your broker will then calculate the right combination of Stamp Duty to 12% deposit and arrive at a purchase price range of $390,000.
(This is assuming any additional costs such as conveyancers’ fees are covered).
Deposit = Stamp duty + 12%
$60,000 = $13,200 + $46,800
A successful property investor knows that saving the first deposit is the hardest and it should be the only time you have to do it, which leads us to Investor 2.
Investor 2 has an existing property and has equity in their property which they can use as a deposit.
Equity is the difference between the value of your property and the amount you still owe. In this example Investor 2 has a property worth $650,000. They still owe $350,000 so their equity is $300,000.
Unfortunately, your bank will not allow you to use that entire amount. Your bank will generally allow you to take up to 80 or 90 percent of the value of your property.
So, in this scenario Investor two would have $170,000 of usable equity if they went to 80% LVR (Loan Value Ratio). You can work out this figure by taking 80% of the value of your property then subtracting what you still owe. That will give you your usable equity. If they required more equity for deposits, they could pay Lenders Mortgage Insurance and go to 90%. This would give Investor two $235,000 of usable equity.
Useable equity can be calculated by:
Property Value X 0.8 = 80% LVR or E.g. $650,000 X 0.8 = $520,000
Useable Equity = 80% LVR - $ still owing or $520,000 - $350,000 = $170,000
You may begin to see how investors with an existing property can take full advantage of their equity and potentially build their portfolio faster.
Each type of investor now knows their BC and is ready to purchase a property. If you have a larger deposit and BC, then you can purchase a higher value property.
Some golden finance rules for investors when looking to purchase:
- Make sure your credit file is clean before applying for a loan
- Reduce any unnecessary expenditure for at least three months prior to applying for a loan
- Ensure there are no overdue or late payment fees for the last 6 months on your bank statements
- Never cross collateralise your properties
- ALWAYS get a pre-approval before making an offer- You will save yourself, your conveyancer, and your broker a whole lot of stress if you have a loan pre-approval in place
Investor 1 can just apply for a pre-approval for their predetermined amount.
Investor 2 will have to release equity from their property and apply for a pre-approval at the same time.
A broker that knows how to structure investment portfolios is worth their weight in gold throughout the finance process. If you were to approach them directly almost every bank in Australia would advise you to cross collateralise your existing property and your new investment. Crossing your properties introduces huge amounts of risk to your portfolio and is not a structurally sound finance option.
A good broker will release your usable equity to its own separate account so it can be tracked easily at tax time. These funds can then be used for deposits and is the low risk way of buying multiple properties with equity.
How to keep on buying:
Investor 1 & 2 have now purchased properties, so their debt level has increased. This decreases their BC.
So how do investors buy multiple properties if their Borrowing Capacity decreases after each property?
One way that allows investors to continue purchasing and obtaining finance is by buying high yielding properties. That means finding properties that receive a very high rent compared to the price that they were purchased for.
This essentially increases your income as the rent from an investment can be included in your BC calculation.
By adding high yielding properties investors can continue to purchase and build large portfolios.
Conversely adding even just a couple of negative geared properties can decrease your BC to zero and destroy your ability to obtain finance or complete your portfolio goals.
The second way is to use lenders that have a more flexible servicing calculator. This can allow you to borrow much more than your average bank and to add the last couple of properties to complete your portfolio. A broker that is an expert at building investment portfolios will have these specialist lenders on their lending panel.
By using the tips and rules above you too can build a retirement size portfolio. With the right finance broker, you do not have to be earning mega dollars to secure your future.
To find out what your Borrowing Capacity is head over to the contact page or click the link below and make a booking at a time that suits.
Kind Regards,
Jason Hare
Mortgage Broker & Finance Consultant
jason@opfinance.com.au
Mb: 0400-805-206
Mb: 0497-408-422 (PA)