Whether you’re a seasoned investor or a newcomer to the real estate market in Australia, understanding how to finance your investment properties effectively is crucial to achieving favourable outcomes. In this blog post, we’ll explore various strategies for financing your investment properties. From tapping into the equity of your existing home and getting investment property loans to navigating other options like guarantor and low-doc loans, we’ll provide you with essential insights to help you make informed decisions and maximise the returns on your property investment.
Equity from an Existing Property
If you own a home in Australia and have built up equity in it, you can use this equity to finance your purchase of an investment property. Equity is the difference between the market value of your property and the amount you still owe on the mortgage. By accessing this equity, you effectively borrow against the value of your home to fund another property purchase. This can also help you bypass the need to save for a large cash deposit. To leverage your home equity, you would first need to get a property valuation and then discuss with your lender or a mortgage broker how much you can borrow based on this equity.
Home Equity Loan
Before knowing how to use a home equity loan to buy an investment property, it’s important to first understand the concept of “usable equity.” While you may have a certain amount of total equity in your home, lenders typically allow you to borrow up to 80% of your property’s value, minus any existing debt. This figure represents your usable equity. For instance, if your home is valued at $800,000 and you owe $450,000, your equity is $350,000. However, the usable equity would be calculated as 80% of $800,000 ($640,000) minus the owed $450,000, totaling $190,000.
To use this equity for purchasing an investment property, you might consider options such as a home equity loan or a home equity line of credit (HELOC). A home equity loan involves borrowing a lump sum against your equity at a fixed interest rate, which is ideal for securing an investment property because it provides immediate funds. Alternatively, a HELOC works like a credit card, giving you access to funds up to a certain limit that you can draw upon as needed. This can be particularly useful for ongoing expenses related to property investment, such as renovations or bridging finance gaps.
When planning to finance an investment property using home equity, approach your lender to get a current valuation of your property and discuss your borrowing capacity. This step is key to ensure that you have a clear understanding of how much you can invest and that your financial position supports additional borrowing. Moreover, it’s advisable to have a contingency plan and maintain a buffer to manage any unforeseen expenses or changes in circumstances without stressing your finances.
Using home equity to buy an investment property not only helps in potentially expanding your portfolio but also in diversifying your investments. However, it is imperative to consider the risks associated with additional debt. Make sure you can manage the loan repayments alongside any other financial commitments, including your current mortgage and the new investment property costs.
Cross-Collateralisation
Cross-collateralisation involves using the equity from one property as security for a loan to purchase another property. Essentially, you are leveraging the value you have built up in your existing property to expand your investment portfolio.
To start, you’ll need to determine the usable equity in your current property – that’s the portion of equity lenders will allow you to borrow against. Typically, lenders will loan up to 80% of your property’s value, minus any existing debts secured against it.
Using this equity strategically can amplify your investment capacity. You can use the equity as a deposit on a new property, thereby reducing the need for cash savings and potentially speeding up the growth of your investment portfolio. However, it’s important to approach cross-collateralisation with a clear understanding of the risks. Linking properties together means that if financial difficulties arise, the risk extends across multiple assets. Additionally, this strategy may limit your flexibility to sell one property independently of the others, as the linked properties are dependent on one another for security purposes.
Investment Property Loans
Investment property loans are loans specifically tailored for properties that will be rented out. As an investor, these loans can have higher interest rates compared to owner-occupied home loans due to perceived higher risks by lenders. Typically, you will need to provide a larger deposit – often 20% of the property’s purchase price – to avoid paying Lenders Mortgage Insurance (LMI). Additionally, lenders will assess your loan application based on potential rental income and your financial stability, so having a solid investment strategy and understanding the financial implications is crucial for success.
Interest-Only Loans
Interest-only loans allow investors to pay only the interest on the loan for a set period, typically five years. Such loans reduce your monthly financial outlay in the initial years, but they do not reduce the principal loan amount. This arrangement can significantly help you manage your cash flow, and it is particularly useful if you anticipate property value increases or plan to sell the property within a short period.
However, you need to have a strategy in place for when the interest-only period ends, as you will need to start repaying the principal, which will increase your monthly payments. Given this, you should ensure your investment property can sustain a switch to a higher repayment schedule without straining your finances. One way to prepare is by setting aside the difference you would have paid on a principal and interest loan during the interest-only phase. This can act as a buffer and help you manage future cash flows more comfortably.
Moreover, using an interest-only loan strategically allows you to benefit from potential tax deductions associated with investment properties, such as deductions on interest payments, which can improve your tax efficiency. Always consult with a financial advisor or a tax professional to ensure that you fully leverage the tax benefits associated with property investment and interest-only loans.
Principal-and-Interest Loans
A principal-and-interest loan requires you to pay both the principal amount you borrowed and the interest on that principal over the life of the loan. Unlike interest-only loans, principal-and-interest loans generally come with lower interest rates. They also help you build equity in your property faster because each payment reduces the principal owed. This can be particularly advantageous if you’re looking at a long-term investment, allowing you to leverage this equity for future investments or to safeguard against market fluctuations.
As an investor, it’s essential for you to secure a loan with a competitive interest rate. Shop around and negotiate with various lenders or engage a mortgage broker to find the best deal. Keep in mind that lower interest rates can significantly reduce your monthly outgoings and improve your cash flow. This is vital for maintaining liquidity and covering any unexpected expenses associated with property investment, such as repairs or vacancies.
Moreover, consider the structure of your loan. Some investors opt for a fixed-rate loan to stabilise monthly payments and hedge against future interest rate increases. This predictability in cash flow can be particularly helpful for new investors who need a consistent budgeting framework. Conversely, a variable-rate loan might offer lower initial rates and flexibility, which could be beneficial if you anticipate a strong cash flow and can manage fluctuations in interest rates.
Finally, always have a clear exit strategy and understand the market conditions in the areas where you invest. Property investment is a significant commitment, and your ability to adapt your strategy to changing market conditions can be just as important as your initial financial setup. Ensure you’re not just relying on capital growth; focus also on properties that can generate strong rental yields to sustain mortgage repayments and other ownership costs effectively.
Guarantor Loans
A guarantor loan involves having a family member, usually a parent or close relative, guarantee part of your loan by offering their own property as security. By doing this, the guarantor provides a safety net for the lender, reducing the perceived risk and often enabling you to borrow more money, or borrow with a smaller deposit without needing to pay LMI.
When considering using a guarantor loan, it’s crucial to understand both the opportunities and risks involved. On one hand, you could benefit from entering the market faster, which might be critical in a rapidly appreciating market. This can also potentially allow for greater capital growth on your investment as you’re purchasing earlier. However, the risks should not be overlooked. Both you and your guarantor should be fully aware that if you fail to meet your loan repayments, the guarantor’s property could be at risk. This arrangement places significant trust and financial responsibility on the guarantor.
To mitigate risks, it’s advisable to have clear agreements in place and possibly seek financial advice to ensure both parties fully understand the terms and responsibilities involved. The use of guarantor loans should align with a well-documented investment strategy that considers your long-term financial goals and current financial situation.
Low-Doc Loans
If you have a non-traditional income source or lack the regular proof of income required for traditional loans, low-doc loans might be a good strategy for you when getting an investment property. These loans are particularly suitable for self-employed individuals or small business owners whose financial documentation does not meet standard lending criteria.
To start, you should have a significant deposit; generally, low-doc loans require a larger deposit than traditional loans, often around 20% to 40% of the property’s purchase price. Be prepared for higher interest rates as well. Lenders typically charge more for low-doc loans due to the perceived higher risk of lending without full income verification.
Additionally, while assessing potential properties for investment, consider your long-term strategy and how it aligns with using a low-doc loan. Since these loans can be costlier over time due to higher interest rates, plan for scenarios where refinancing might be possible once you can provide more comprehensive financial records or when your credit standing improves. Effective financial planning and risk management are crucial, especially if you aim to transition to more conventional financing solutions in the future.
Lastly, consult with mortgage brokers who specialise in low-doc loans. They can offer insights into the best available products and guide you through the lending criteria specific to your financial situation and investment objectives.
Using SMSF
Using a Self-Managed Superannuation Fund (SMSF) to buy an investment property allows SMSF trustees to potentially leverage their retirement savings on a tangible asset, providing both rental income and potential capital gains.
When using this approach, firstly, you must ensure that your SMSF is set up correctly with a clear and compliant investment strategy that includes property investment. The property purchased must meet specific regulations; it cannot be acquired from a fund member or related party, and it must be solely for the purpose of retirement benefits. You’ll need to decide whether the property will be residential or commercial. For residential properties, it’s important to note that no fund member or related party can live in or rent the property. However, SMSFs can purchase commercial properties that can be leased back to a member or related party, provided it’s at market rate and strictly for business purposes.
Financing a property through an SMSF usually involves a limited recourse borrowing arrangement (LRBA). Under an LRBA, the SMSF can take out a loan to purchase a property, with the property being the only security for the loan. This means that if the SMSF defaults on the loan, the lender’s rights are limited to the property held in the trust associated with the LRBA, protecting the other assets of the SMSF. Make sure that your fund has sufficient cash flow to manage loan repayments along with other fund expenses, including maintenance, rates, and insurance, without compromising the liquidity of the SMSF.
In planning your investment, consider the property’s potential for capital growth and rental yield, along with the tax advantages such as deductions for interest payments and property expenses. Always seek professional advice to navigate the complexities of SMSF property investment, ensuring compliance with the Australian Taxation Office and superannuation laws, and aligning with your overall retirement goals.
Construction Loans
Construction loans are for investors looking to build investment properties or undertake significant renovations. Unlike standard home loans that provide you with a lump sum payment, construction loans release funds in staged payments, or drawdowns, that correspond with each phase of your construction project. This means you only pay interest on the amount drawn down, not the entire approved loan amount, which can significantly reduce your interest costs during the construction period.
To utilise a construction loan effectively, ensure you have detailed and realistic construction plans and budgets. These are necessary for securing loan approval, as lenders need to assess the feasibility and profitability of your project. Work with experienced builders and architects who can provide precise estimates and timelines for your development project. This detailed planning not only aids in loan approval but also in managing the project efficiently, avoiding costly overruns and delays that can impact your financial returns.
Moreover, always have contingency plans for unexpected expenses or delays in construction. Lenders will look favourably on a well-thought-out project plan that includes buffers for unforeseen costs. Demonstrating that you have considered various scenarios and have plans to mitigate risks can make it easier to secure financing.
Commercial Property Loans
Commercial property loans are specifically tailored for purchasing commercial properties such as offices, retail spaces, warehouses, and other business-related premises. It’s important to understand that these loans typically offer features like longer loan terms and larger borrowing amounts, which are adjusted to suit the scale and needs of commercial investments.
As you assess your options, keep in mind that commercial property loans often require a lower loan-to-value ratio (LVR) compared to residential loans. This means you may need to prepare for a larger deposit, generally around 30% of the property’s value. This higher equity requirement ensures you have a significant investment in the property, reducing risk for the lender. When planning your finances, consider this as part of your investment strategy, as it impacts your upfront costs and your borrowing capacity.
Moreover, commercial property loans may come with varied interest rate options, including fixed, variable, and interest-only payments. Choosing the right interest structure depends on your cash flow needs and risk tolerance. Fixed-rate loans can give you stability in repayments and aid in budgeting with predictable costs. On the other hand, variable rates might offer lower initial rates, which could be beneficial if market rates decrease. If cash flow is a primary concern, especially in the early stages of your investment, an interest-only loan can lower your repayment obligations temporarily.
Loans from Non-Conventional or Private Lenders
If traditional bank financing is not available or suitable for your needs or situation, you can explore loans from non-conventional lenders, such as private lending firms or non-bank financial institutions. They offer a range of loan products that can be tailored to different investment scenarios, including those involving unique property types like commercial spaces or unusual residential properties that might not meet the criteria of mainstream banks. Non-conventional lenders can also provide more flexible lending criteria and faster approval times.
As you evaluate your options with private lenders, you’ll find that these entities often focus on the asset’s value rather than your credit score alone, making them an appealing choice if you have a less-than-perfect credit score or need more flexible lending criteria. Private loans can be structured quickly, which is beneficial if you need to close a deal quickly. However, it’s crucial to understand the terms, as interest rates might be higher, and the loan structures could vary significantly from traditional loans.
Before proceeding with a private lender, ensure that you conduct thorough due diligence. Check the lender’s credibility, review all terms of the loan agreement, and understand any fees or penalties involved. It’s also wise to speak with a financial advisor or mortgage broker who specialises in non-conventional lending to help you utilise private lending effectively.
Final Thoughts
All of the above-mentioned strategies can be useful tools for property investment. Nevertheless, it is important to remember that each of these options has its own benefits and risks, and requires careful planning and management. As an investor, you should consider consulting with a financial advisor or mortgage broker to thoroughly understand the implications and tailor your approach to your specific financial situation and investment goals. This helps ensure that you can maximise the benefits while mitigating the risks associated with property investment financing.
