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Most investors are not in a position to buy an investment property outright. So getting appropriate finance during your investment journey is a crucial part of your future success. In this episode, Damian and Arin discuss the difference between good and bad debt, and what key criteria lenders use to assess your loan application. They will also explain correct finance structures and why to avoid cross-collateralisation.
Welcome to episode 6 of our property investing masterclass
We discussed different price bands and timing the market in our episode last, and this week we dive into the topic of how to finance your properties.
Arin and Damian discuss the difference between good debt and bad debt, and why it is important investors understand the difference. They also explain the concept of cross-collateralisation and what criteria banks use to review someone’s loan application.
Tune in and Learn:
What is good and bad debt?
What criteria do lenders examine when reviewing loan applications?
What do Loan-to-Value Ratio and Serviceability mean and what is their impact?
What is cross-collateralisation and why should it be avoided?
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Podcast Transcription
Arin Di Camillo, Momentum Wealth: Welcome and thanks for tuning into episode number six of the Momentum Wealth podcast series. My name’s Arin Di Camillo, Manager of the Property Wealth Consultancy at Momentum Wealth. Joining me as always is Damian Collins, our founder and Managing Director. Damian, thanks for being with us.
Damian Collins, Momentum Wealth: Great to be here again, Arin.
Arin: Excellent. This Momentum Wealth podcast series is a 10-part series in which we’re looking at the fundamentals of property investment. If you haven’t seen the previous five episodes, please feel free to jump on the website and check them out. Some great content that we’ve gone through already. Now, property investment, it’s more than just buying the right asset, we say it every week. But it’s so important that other things are taken into consideration.
Damian: It is, Arin. I’m glad we’re going to cover a lot of these in our 10-part series because, you know, buying that right property, which is obviously a focal point of this series is still critical. When we’re building our property portfolio, it still comes down to getting the right strategy in place, getting the finance right, which is what we’re talking about today, looking at other ways to value-add, speed up your wealth developments and also managing your properties well and even looking at commercial properties and syndicates as opportunistic ways to get into some of those other areas that maybe you couldn’t afford to on your own. So, there’s a lot more to it, but unfortunately most people out there just talk about residential passive investment. That’s a key part of it, of building a large property wealth portfolio, but there’s more to it than just that.
Arin: There sure is. And even with residential property investment, finance becomes a key part of it, and that’s a topic we going to discuss today.
Damian: It’s really, really crucial.
Arin: So, a big one to go through. Finance is super important to a good investment strategy. We going to cover that today. Also, as usual, we have a bonus for our listeners at the end of the episode, so stay tuned and I’ll give you the details of today’s bonus. So, should we get straight into it?
Damian: Let’s go Arin, looking forward to it.
Arin: Excellent. All right. First up, let’s talk about debt, that’s what finance is all about. Now there’s such a thing as good debt versus bad debt. Talk us through the differences between the two.
Damian: Well, let me start with the bad debt. In fact, I put into three categories: good debt, bad debt, tolerable debt and bad debt, really bad debt. So, I guess good debt is debt that’s utilised. So, assume we borrow money from the bank, obviously, we’ve got to pay them back sadly, that’s the way they work unfortunately.
Arin: Part of the game.
Damian: So, they want their money back. And also, not only that, they want to charge interest on that ,as well as fees so they get their pound of flesh. So, if we’re borrowing from the bank and paying them money, and they obviously use that to run their business and pay the people who put deposits in the bank accounts, we need to make sure that whatever we’re paying the bank, whatever investment category we’re putting that to, we’re getting a better return. So, good debt is debt that’s used for productive purposes where it may… it’s going to increase our wealth. And that obviously in the property market context and what we’re talking about here today is most people, they’ll borrow money to buy potentially a residential investment property. So, that is good debt, but when I say good it’s only if it’s… you know, you’ve still got to buy the right asset. It’s got to be structured correctly.
Arin: It’s got to be used the right way.
Damian: Which we’ll talk about today, that is good debt because it’s put to productive uses that will actually increase your overall wealth. The bad debt I guess can be put into two categories. So, a home loan is, for example, potentially, it’s bad debt but it’s borrowing for purposes that are not deductible, but I guess the upside to that is that if you didn’t own a house, you’d have to rent somewhere. And your house, again if it’s a good asset, will increase in value over time, hopefully, more than the interest you pay on that. So, that is the second level, I guess good debts for investment. In terms of your bad debt, the home not ideal but most of us have to borrow to get a house, so that’s just the way things are. But the really bad debt is debt for non-productive purposes.
So credit cards, so you go into debt for holidays, for just general spending. You’ve got nothing to show for it except maybe a good time, but you’ve got no investment and so you owe all this debt and that’s the sort of stuff… Then car loans, again you’re buying a depreciating asset and yet you need to get around. So, look at all those things. You want to go on holiday, we appreciate that. You might need a car, you might need to borrow for that. But, we want to clear those things off as quick as we can because that’s really unproductive debt and certainly can have a significant impact on the amount of wealth that you can create over a longer period of time.
Arin: So, when we’re looking at a client’s personal circumstance for their own benefit, we’re looking at reducing their bad debt wherever we can and making sure that good debt is good debt. But from a lending point of view as well, the banks prefer good debt versus bad debt. They don’t like to see clients with a lot of bad debt.
Damian: Well that’s it because, when they’re doing their calculations and whether or not you can borrow money from them, if you’ve bought an investment property, they will take into account the interest expenses that you’re going to pay. And they might even put that at a higher rate than the actual rate you’re paying in terms of their calculators, but they’ll also generally credit you with that income. And so you find that if you’ve got a property that you’ve had for a few years, it may not be that… [it may not have] as a big an impact on your ability to borrow if you’ve got a rental property.
But we find that credit cards particularly and personal loans are brutal because what they do is, they take into account not your credit card balance, but your credit card limit. So, we’ve had clients come in and they go, “I’ve got $100,000 credit card limit but I pay it off in full.” Even though they’re good and disciplined people, the banks go, “Well that’s fine, but we’re going to assume 3% of that a month. It’s going to go to 36 grand a year… we’re going to wipe off your income, after-tax income.” And that’s horrible, that just kills a lot of people. And the other one is car, yeah, car loans they don’t take into account the interest they take out all the payments, that could be, you know, $700 or $800 or $1,000 a month, that’s also very brutal as well. So, they’re terrible for your servicing and we’ve told clients in the past to cut up credit cards, particularly even if they pay them off in full, they’re really bad for your lending ability, absolutely.
Arin: So, we’re exploring that further. We’re going into what lenders are looking for in terms of assessing your client situation. There are four main parts to it. The loan to value ratio first of all. The serviceability of a client, which is their ability to lend money from them or the amount they can borrow. Then looking at credit history, whether they have a clean record or not, and also the actual property details itself – is it a suitable asset for the bank to take security against? I’m going to go through these in a bit of detail. I’ll hit you up for some answers as well if that’s cool. All right, we’ll start with LVR or loan to value ratio. What is it and how does it impact the lending process?
Damian: So, this is where people get a bit confused. There are two types of equity we talk about when we’re talking to clients, there’s your actual equity in a property. So that might be, keep it simple, you’ve got a property worth half a million dollars and let’s say you owe $400,000 on it. Your wealth or your equity in that property is $100,000 simply by deducting $400,000 from the $500,000, nice and simple. But, that’s not the amount of money you can utilize to buy your next investment if you want to borrow. So, if you go back to the bank and say I want to borrow against that property at 80%, they’ll do loan to value ratio and they’ll say, “At 80%, you’re already fully maxed out in terms of your borrowing capacity.”
Now you can go a bit higher on residential property but you start to pay mortgage insurance, which we may or may not talk about today. But certainly what you find is that, you know, you can go to 90%, that’s only $450,000 means you can only borrow an extra $50,000. You can’t borrow the 100% of your equity. So, there is lending equity, that’s the amount that you can borrow against that asset and then there’s your actual equity, which is your wealth in that property. There are two important things and what we find, you know… the lenders go in cycles, up and down. Eighty percent is pretty standard on most residential properties although some, which we’ll talk about that one, some are less but for most properties 80% is okay. In metropolitan cities, pushing up to 90% is possible but you start to… 95% is pretty hard to get these days.
Arin: The other consideration when talking LVR is of course what the reasonable sale price for that property is versus what valuation we might get from a lender. So, you see even when you’re in a circumstance where you’re at a particularly favorable valuation, we still need to be conscious of what the actual sale price of that property is when we’re talking about a client’s investments. So that’s one thing where people sometimes tend to max themselves out, borrow all the way up to the top and it can lead to some issues down the track.
Damian: Yeah. Look, the valuation, I guess it’s loan to value, not what you think it’s worth or what your local real estate agent thinks that it’s worth, it’s the loan to the value that’s set by the valuer. So, look it’s… valuation is a bit of a science but it’s a bit of art as well. And we’ve seen situations where three valuers have, you know, different opinions sometimes plus or minus 10% from each other of what the property is worth. So, just be conscious of that, it doesn’t mean the valuation… sometimes, a lot of times they come in lower than you think it’s worth. And so you might think you’re property is, that example before, worth half a mill. We go to the bank. We arrange the valuation through the bank and the valuer says $450,000, that changes your plans there as well. So, be conscious of that. It’s not what you think it’s worth, it’s what a valuer thinks it’s worth.
Arin: That’s right. Now the second fact… that a bank will look at when assessing your client’s suitability for lending, is serviceability. Talk us through how serviceability works.
Damian: So, in simple terms, it’s the bank is doing a budget for you to see if you can afford the loan. So they’ll say, “Okay, well let’s say you earn $150,000 and the tax on that income, let’s say might be $30,000 just to keep it simple, you’ve got $120,000 left. So, what are your living expenses then that come off that? What are your home loan payments?” Let’s say we’ve already got a home but we’re buying an investment property and they’ll also look at your other debts that you’ve got. So, we mentioned before credit cards, they are pretty brutal on how much they put in your servicing for that and personal loans etc.
So, an important thing to think about is you might be saying at the moment, “I can afford this loan I’m paying,” you know, let’s say it’s four or five percent depending on where the market’s at and the interest rate cycle but the lenders often load that, they do their own scaling just to protect you but also protect them. So, they might scale that at 7%. So you think, “Well, I can afford this loan paying 4%,” but they are going, “Well we’re going to service you on 7%.”
So, they also take into account children. Sadly children are another one that’s bad for your credit unfortunately. If you’ve got a couple of kids, they’ll put them as expenses as well. So they go through a process… again, unfortunately, they’re doing it a different way [from what] you would. They load things and for risk you might think you can afford it but they basically go through a process to make sure that they’re comfortable loaning you that money as is their obligation to the National Consumer Credit Code. They need to do that just to make sure that they’re comfortable because they don’t want you not to be able to pay that loan as well.
Arin: That’s right. I guess in serviceability as well each lender is different for every scenario too, aren’t they?
Damian: Oh absolutely, and that’s why you go and see a broker who knows what they’re doing in that investment space because they’ve all got different rules and regulations and it’s amazing what you can come out with. And, you know, I’ve seen our brokeing team sit down with clients and particularly the more complex the circumstances, the more the variations. I’ve seen with some lenders they might say, “Oh, you can borrow $1.2 million and other lenders say $400,000,” it’s a massive difference.
So yeah, just… personally it makes no sense to me why anyone would go to a bank direct. The bank is there to make money and fair enough and everyone’s got to get paid but at the end of the day, one bank is not going to be able to help you build an investment portfolio. I’ve strewn my loans and with my broker across many lenders, it’s the right lender for me at the right time and you mentioned cross-collateralisation, which we’ll talk about. Let’s not cross-collateralise in your properties as well.
Arin: Very important, third part or third factor that a bank will look at when determining the suitability, they’ll look at credit history. Now, it does happen that occasionally people do have some blips in their history that makes it a bit trickier to get credit for them.
Damian: It does. So, an important part of your process is when you are sitting with your broker is to get a copy of your credit file and have a look at that and… we’re still in that market in Australia. A lot of other countries have positive credit scoring, so you get actually a score. So in the US, for example, a credit score is very important, “Oh wow, mine’s more than a certain amount, that’s a good credit score.” In Australia, we’re still a bit of a blend. We’re trying to move to that model but we’ve still got a lot of what they call negative scoring. So, it doesn’t show your payment history.
So […] it just shows what loans you’ve applied for and if you’ve missed… if you’ve defaulted on any. Also, court judgments come up as well. So, any court lawsuits as well, if you’re getting sued by anybody that’s also… And some of the worst ones are the simple ones like rate notices. You know, you might have moved house and if you’ve got to update an address, an old rates notice for an investment property get sent there, and low and behold, all of a sudden they don’t muck around. They send it off straight to the courts and you get a default judgment. So, they’re the sorts of things that now we can clean those up. Your broker can clean those up if they’re innocent mistakes, which often they are but just be aware of that if you’ve got credit blemishes where you haven’t paid bills in the past, telecommunications companies etc., they then report to these credit authorities and it can certainly impact. So, I always say you should pay your bills on time generally but if you’re ever in life struggling make sure you pay the bills for the ones who are likely to report you to a credit authority because they’re the ones that could impact your ability to borrow money later.
Arin: And get to the important ones the first for sure. The fourth part of the lending criteria, we’re looking at the actual security itself, the type of property. Lenders have different rules for different types of properties and that can affect what they’ll lend against it.
Damian: Absolutely. So, what you find is that if you’re buying a typical house in suburban Sydney, Melbourne, Brisbane, Perth, they’re generally the assets that they like to lend on depending on your credit circumstance. But, assuming everything is clear, you might be able to borrow 90% or even maybe a bit more on those types of properties, but the banks again risk mitigation, put different thresholds. So, for example, inner city apartments they might cap it at 80% or 70% in the market. Sometimes they just have blanket bans, they say we’re not lending in this particular market or this particular location. We’ve seen that in the mining towns. They’ve reduced their loan to value ratios. They’ve even in some cases banned future lending in those locations which certainly makes, exacerbates the downturn in those markets. Then you get serviced departments, they might cap those at 65%, [and] commercial properties again, 65 generally maybe 70%. So, it’s all part of their risk strategy. They’re making sure that they feel comfortable that there’s enough equity in the deal from the buyer to protect them. So yeah, a lot of properties have got quite different loan to value ratios.
Arin: Sure. Now, so by and large the lenders use the same criteria more or less to assess an applicant’s suitability for a loan and how much they can borrow. They all use roughly the same criteria, but they are different in how they assess things. Going back to serviceability obviously, that’s what a particular lender will lend to a particular scenario, but it’s important that people have their own idea of what they can reasonably afford. Just because the bank can lend in that amount of money, doesn’t necessarily mean it’s right for them to take up that full amount of debt.
Damian: Well that’s it. And particularly, you know, you’ve got to assess your living expenses, what sort of lifestyle you want to lead. And, you know, what you might have to make some sacrifice, but you don’t want to be living hand-to-mouth and there’s a happy balance there. I always say to people, “If you’re going to invest in property and build,” well, you know, in life, there’s always going to be some sacrifice. You can either make a small sacrifice as you’re going through and yeah maybe you don’t get to spend as much as you would like, you’ve got to invest some of that in keeping up the property as you go along. But if you don’t sacrifice then, you’re going to make a big sacrifice in retirement when you got 25 years on the pension at a pretty low rate of income. So, you’ve got to be willing to make a sacrifice but you’ve got to be still comfortable. I guess there’s a fine line. You’ve got to keep your family and yourself happy, but you will have to make some level of sacrifice. So, you need to assess, “Am I happy with that amount of money being available for us to live our day-to-day life?”
Arin: So, I guess the message there is even if you get approved for a certain amount, it doesn’t necessarily mean you should use all of it. You need to factor in your own household costs and your lifestyle choices.
Damian: Exactly. You’ve got to be doing your own numbers with conjunction with your broker. Make you feel comfortable that you can afford it and still live a decent enough life that you want to live.
Arin: Now, shifting topics now, we did touch on this in a previous episode. A really important one for investors and certainly something that our investors have learned a lot from, but the importance of not cross-collateralising within a property investment portfolio. The banks obviously are always super keen to get a hold of everything you’ve got because that’s their security, that’s their business. But for our investors, it’s really important that we separate things and use equity from different lenders.
Damian: So, in summary, cross-collateralisation, a lot of people don’t understand what it is. And it’s the simplest way to figure out if you’ve cross-collateralised is to look at your loan documents and if it shows more than one, it says “security,” and if it shows more than one property, sorry to tell you, you’ve cross-collateralised.
And what is that? It means cross, it means multiple collateral, multiple properties being secured for a loan or a number of loans. And so, if you go to a typical bank, they’re trained to cross-collateralise because that keeps the client stuck to that bank. They can’t just wander off easily to do something else. So, it’s also simpler, to be honest. It is easier to go and cross-collateralise.
Instead of, let’s say you had a property worth a million dollars and you had half a million dollar loan on that property and you bought another one for say $500,000. If you want to cross-collateralise, you go to your bank or even your broker say, “Hey, here’s the property.” And they go, “Great, we’ll stick it all together.” And all of a sudden you’ve got two properties and you’ve got two loans, but the security is both properties because they won’t lend you 100% to buy the new one. They’ll use effectively the lending equity in the first property that you’ve got and that can… that could pose as problems down the track.
Arin: Sure. Just to touch on a point you raised there, for a bank, very easy for them to cross-collateralise because they want all these securities. But even most brokers we see, if they’re not in tune with sound investment practice, they’ll cross-collateralise just because it’s simpler. They can do one application, get it approved with one lender, and it’s a really easy fix.
Damian: It is and that’s sad but a lot of brokers, I guess, don’t understand the implications for a client who’s looking to build a large property portfolio. They just stick them together and, look, it might not be a problem at that time and even maybe one more property, it might not be. But then when you get to that building, that larger portfolio, it can become a significant problem, particularly if one property drops in value as they sometimes do in the cycle. The thing is, when everything’s crossed every time you do anything, they revalue your whole portfolio which can be problematic.
Arin: So, I hope that explains for the viewers what cross-collateralisation is. What are some of the negative impacts though? In real terms, what will happen to an investor, what restrictions will they be faced with if they are cross-collateralised?
Damian: Well, the first one that I just mentioned there. So, if you’ve got let’s say eight properties in your portfolio, they’re all separately secured, stand alone, they’re not secured by another property. Well then, let’s say you need some additional equity. You might have one property in one city or one location that’s performed really strongly, you can just get extra equity against that one. You don’t have to go and get… the one that’s gone down revalued as well. So, you only… you can pick your winners and you don’t have to deal with your losers at the same time. The other really important thing is that it gives you a lot more flexibility. If you’re with one particular lender and they’re all cross-securitised or cross-collateralised, it becomes very difficult to move to another lender.
And so we spoke earlier that sometimes a lender… you know, the same client, one lender might say $400,000 and one might say $1.2 million, that’s the way their servicing calculators work. That’s a huge difference. Now, if you’re with the bank that says $400,000 more and you’re buying a property for $550,000 with that lender, you’re stuck. You cannot buy anymore and we’ve been [able to] unpeel, you know, slowly unpeel a banana and move it around, but it can take six to nine months and sometimes longer, [and] really hold you back from your investment journey. And in some cases, if it’s a situation where [you’re] kind of stuck as well.
So, no lender is ever going to be the right lender for all your properties. It’s just crazy and so don’t deal with the bank direct. You’ve broker channels out there now who’ll find you those opportunities. And secondly, when you’re choosing a broker, find one who understands investment property.
Arin: So we’ve covered a lot of ground today in the finance space, talking about particularly cross-collateralisation. One last part before we go and you just touched on it then, just how important is it to have a mortgage broker that specialises in investment finance as opposed to a normal bank or broker?
Damian: It’s absolutely crucial, Arin. And it certainly helped me to get to my large property portfolio, I was using a broker who knew what they were doing. If I’d gone to one bank direct, I never would have got the property portfolio that I have. I’d have never got to that size just pure and simply because no one bank would have been right for me all that way through. So having, you know, we spoke, you know, we talk about it each episode that we’re saying the crucial factor is not just buying the right property, it’s all those other things. And finance is almost as important as buying that right property because if you can’t get financed, that property doesn’t even… the next property doesn’t even come into play as well. So, finance is absolutely crucial.
You’ve got to get that broker who specialises in investment finance, understands what to do, because that can mean the difference between maybe two or three properties and maybe eight or nine properties.
Arin: And one thing we always recommend to our clients is putting the finance structures in place prior to the acquisition of the property to make sure you know exactly what it’s going to look like.
Damian: Definitely. And it’s about, you know, we’re accessing equity and those other properties as a standalone not cross-securitising them, again your good broker will know how to do that. So, you’ve got the money ready to go so you know when you find that great property, everything’s set up and you can buy it with comfort.
Arin: Excellent. All right, that’s all we’ve got time for this week. Damian, thanks again, always a pleasure to have you here. Before we go, this week we’re offering another bonus sheet available with the summary of the discussion today on the website. Plus an additional article that again explains crossed-securitisation or cross-collateralisation and in-depth discussion about why it’s a negative impact on investors.
So, check out www.momentumwealth.com.au/podcast, check out the information there and download the material, well worth a read. Now we hope you join us next week. Next week we talk about one of the sexier parts of property investment which is development. Lots to cover in the development side of property investing. So, a fairly big episode next week right from putting a development together, whether it’s suitable for you and also we’ll cover some of the risks involved in property development. Thanks again for tuning in. We hope you enjoyed the podcast and we look forward to your company next week.
