When investing in property, take care to structure your finances correctly or you could find yourself in a worse financial situation than where you started, especially in times of stagnant or declining property prices.
Example
Take Bob and Sarah Smith as an example. After 10 years of running their own small businesses, they are both now working full time, Bob as a clerk, earning $60,000 (Aust.) and Sarah as a cashier, earning $20,000 (Aust.). Being employed full time gave them the time and impetus to consider property investing.
Their first purchase was a 2 bedroom apartment in the outskirts of town. They borrowed $313,000 against the property which was valued at $303,000, using their own home as additional security. It is rented out at $240 (Aust.) per week.
Their second property was an "off the plan" purchase which wasn't due for completion for 2 years. They paid the 10% deposit up front by way of a personal loan at the advice of an inexperienced broker.
Both their initial home loan and the loan on their first investment property had been set up incorrectly as Principal and Interest loans over 25 years. Adding the personal loan and a credit card debt to these meant that their outgoings were huge, compared to their income and the loans they were servicing. They were headed for a financial disaster when the time came to settle on the second property. To add to the mix Mrs Smith and her daughter wanted to buy into a small franchise and draw on the equity in their home.
Original Scenario
DESCRIPTION Original Valuation Value of loan Interest Rate Repayments/month
Own home $380,000 $220,000 6.9% $1,547
Property 1 $303,000 $313,000 6.9% $2,198
Property 2 $283,000 (deposit) $28,800 11.5% $637
Credit Cards $15,000 16% $450
TOTAL $576,000 $4,832
Result
Bob and Sarah were facing four possible options if they retained the above loan structure:
1. Being forced to sell the second investment property upon settlement as they couldn't cope with the repayments.
2. Not be able to obtain finance or even settle the second property and losing their deposit and the $27,000 capital gain.
3. If they had kept going as they were and managed to settle the second property they may have started defaulting on loan repayments and paid more interest through the debt consolidation process by having to apply for a bad credit loan.*
4. Work harder and more hours to cope with the additional financial stress of an additional $1743 per month of outgoings.
Restructuring Issues
In the process of restructuring their portfolio there were a number of issues to consider:
1. There had been a recent interest rate rise and another imminent. Not only did this add to the size of their repayments but also negatively impacted the valuations on their own home and the first investment property, dropping $55,000 and $13,000 in value respectively. The second investment property increased in value by $27,000. This pushed the loan to value ratio (LVR) above 80%.
2. Sarah and her daughter's intention to purchase the franchise business.
3. Limited incomes to service the loans.
New Scenario
DESCRIPTION New Valuation Value of loan Interest Rate Repayments/month
Own Home $325,000 $235,000 7.29% $1,427
Property 1 $290,000 $338,000 7.29% $2,053
Property 2 $310,000 $279,000 7.5% $1,743
TOTAL $925,000 $825,000 $5,223
Note:
Credit card debts were consolidated into the loan on their own home increasing it from $220,000 to $235,000.
The $28,000 personal loan for the deposit on the second investment property was consolidated to the investment side of the loan on the first property increasing it from $313,000 to $338,000 (the personal loan had reduced over the 2 years from approx $28,000 to $25,000).
These loan figures did not have Mortgage Insurance (LMI) premiums included. The premium was approx. $15,000 and the total LMI was capitalised to the investment portion of the loans. This allowed for tax effective structuring, (established in conjunction with accountant's advice).
The second investment property was put to a different lender as this lender was able to lend against the recent valuation of the property, not the original purchase price.
New Result
The end result was Bob and Sarah settled on the second investment property with only a $400 per month increase in total outgoings. This was more than offset by a rental return on this property of $1213.00 per month.
Sarah obtained an unsecured business loan to buy the franchise. This eliminated $30,000 from being included in the calculations meaning Bob and Sarah were left with their portfolio being completely property related, apart from the consolidation of the credit cards.
* If you have defaulted on repayments this could have a negative affect on your credit rating. There are many websites that will provide a free credit report so you can assess your situation.
Colin Kidd, is the CEO of The Loan Saver Network a financial services company specialising in helping families who have been turned down by the banks.
