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STRUCTURING FOR THE FUTURE

How can you avoid being trapped in a bad loan structure? BY STUART WEMYSS

A poor loan structure  is the most insidious  and commonly overlooked mortgage issue by investors, accountants  and mortgage brokers. In my article last year (published in the February/March 2004 issue of API) I set out a step-by-step example of how an investor should build and structure their loan portfolio. Following a positive response to the article, it was obvious that investors were thirsty for more information about this topic and so they should be, given that it’s difficult to get good loan structuring and product advice. This article will discuss other loan structuring issues in detail. Part 3 of this series (to appear in the next issue of API) will focus on loan structuring issues when investing through companies and trusts.

FIXING A BAD STRUCTURE

They say that knowledge is power. Nothing could be more true when it comes to dealing with the banks. Often the people that have the most trouble getting the banks to do what they want are the people that are the least confident about what can and can’t be done. Therefore, being informed is your best weapon to making sure the bank does what you want them to do.

Perhaps it’s best to define what I mean when I refer to a ‘bad structure’. In my opinion, a bad structure is one that has cross-securitisation and perhaps a lack of separation between debts (ie. it’s difficult to identify what debt relates to what property).

A simple definition of cross-securitisation is where a loan is reliant upon more than one property for security (refer to my first article for a discussion about the cons of cross- securitisation).

Often unwinding a debt structure can be difficult. The reason is that a bad loan structure  is generally good for the lender because it provides them with better security and ‘ties’ you to them (ie. makes it harder to leave). Therefore, there is little incentive for the lender to change your loan structure. Furthermore, often there is no incentive for the staff member to help you. Changing  a loan structure  might take up a lot of their time – it’s essentially a whole new application. However, often staff members are only rewarded for new debt. As such, they might be reluctant to spend time changing an existing structure where there’s nothing in it for them.

Combine these two factors and you’re likely to experience some ‘push back’ when you ask to uncross-securitise your loans. Unfortunately, the only way to deal with this issue (if your initial kind requests have been overlooked) is to threaten to take your business elsewhere. Often that provides them with enough incentive to ensure your requests are promptly attended to.

Generally, fixing a bad structure involves changing/splitting a few loans. Often professional packages will allow you to do this at no (or very little) cost.

By way of example, let’s assume an investor has a primary place of residence and one investment property. Their home is worth $500,000 and the investment property is worth

$300,000. They have a home loan for $100,000 and an investment loan for $310,000 (which was used to pay for the investment property plus costs). The investment loan is cross- securitised  with the home (ie. one loan reliant upon more than one property as security = cross-securitisation).

What we need to do is split that one investment loan into two parts.

The first part needs to be the maximum amount that can be secured by the investment property, which is normally limited to 80 per cent of the property’s value to avoid mortgage insurance (ie. 80 per cent of $300,000 = $240,000). The remaining portion of the investment loan can be secured by the home.

Before restructure
$100,000 secured by home
$310,000 secured by home and investment property

After restructure
$100,000 secured by home
$70,000 secured by home only
$240,000 secured by investment property only
The important thing is to structure your portfolio so that you can identify what debt relates to which property and to avoid cross-securitisation. If in doubt, then seek independent advice from a knowledgeable professional.

It may not be possible to undertake any restructures while your loan interest  rate is fixed. The reason for this is that altering a loans structure may trigger significant break fees. Therefore, you may have to wait until your fixed rates expire before optimising  your structure.  I’ll talk more about this later.

CONSIDER THE COST/BENEFIT

Many of the larger lenders offer professional packages. Professional packages normally bundle up a number of banking products (for example: home loan, credit card and transaction account) and offer interest rate discounts.  One of the benefits of these packages is that many of them allow customers to apply for a number (sometimes unlimited) of separate mortgages without any extra upfront or ongoing fees.

These packages are perfect from a loan structuring perspective because they allow the customer to set up the perfect structure every time. However, if you cannot benefit from a professional package for some reason then you have to weigh up the costs and benefits of having an optimal structure.

For example, avoiding cross-securitisation may involve having to set up two separate loans. That may mean

paying for two application fees and two monthly fees. In this situation, I would not always suggest that this is the best way to go. You still need to be mindful of costs, and you need to find the balance between minimising costs and having an optimal loan structure.

2 structure

STRUCTURING AND MORTGAGE INSURANCE

Lenders charge lenders’ mortgage insurance (LMI) when a person borrows more than 80 per cent of a property’s value. LMI covers the lenders risk, not the borrowers.  The cost of LMI is dependant on the loan amount and the loan-to-value ratio (LVR).

The higher the LVR and the larger the loan amount,  the more costly LMI can be. However, this cost can be minimised by structuring individual loans effectively.

Perhaps  the best way to demonstrate this is by way of example. Let’s assume that an investor owns two investment properties and needs to increase his lending by $60,000 in total to fund another property purchase.

Assume the property and loan values are as follows:

The difference in cost between option one and two is over $750. Therefore, it’s certainly worthwhile crunching some numbers on what structure is the most cost effective if you ever need to borrow more than 80 per cent and pay for LMI. I’ve used the LMI premium rates from one of the “big four” lenders (excluding stamp duty) to estimate the LMI cost in this example. It’s important to note that the cost of LMI can vary greatly between lenders.

For example, in option two, the cost of LMI can decrease to $4464 just by using a different lender (still a “big four” bank). That amounts to a saving of over $2000. This illustrates the benefit of having a flexible loan structure and being able to use any lender you like (i.e. not being tied to one lender) and making sure you seek the right advice.

Another point to keep in the back of your mind is that the mortgage insurers may offer you a partial refund of mortgage insurance if your LVR reduces to 80 per cent or less within

12 to 18 months.  For example, if you purchase a property for $300,000 and borrow 85 per cent (i.e. $255,000) and the property value increases to $320,000 after nine months then your LVR has reduced to less than 80 per cent. All you need to do is reset the loan term and ask your lender to apply for a mortgage insurance refund.

FIXED RATES BE WARNED

Be very careful with the use of fixed rates in a loan structure. The combination of a bad structure and fixed rate can be crippling. The reason is that fixed interest rate loans have the effect of freezing a structure into place for the term of the fixed rate. This is because you may trigger break fees if you have to change anything in the loan documents of a fixed rate loan (for example change security, repayments, etc.). The break fees on fixed rate loans can be anything from nil to tens of thousands of dollars.

Firstly, I would use caution with a fixed rate for an investment loan unless you have a very firm reason for doing so. The reason for this is due to the fact that investors tend to change their loans more often than owner-occupiers. Changes might include increasing a loan, selling the property or changing lenders. A change of investment strategy or an opportunity presenting itself can be enough to motivate a change in lending.

Secondly, if you’re going to fix one of your loans then make sure the loan is stand alone (that is, not cross-securitised). That way you minimise the chances of triggering break fees.

BE SENSIBLE ABOUT THE USE OF PRODUCTS

 Often lenders will charge more for line of credit products compared to basic variable products. Sometimes basic variable products have restrictions and costs involved with redraw which can make them difficult to use.

Most investors like the flexibility that lines of credit offer. For example, writing a cheque directly from a loan account when paying a deposit for their next investment property purchase is very handy. You can have your cake and eat it too!

What I would suggest is having a small line of credit that you would use on a temporary basis. You could use it to pay for the initial 10 per cent deposit. Then when you apply for the main basic variable loan, make sure you ask for enough funds to repay your line of credit on settlement day. That way you can ‘shift’ more expensive line of credit debt over to basic variable debt. Your line of credit balance is then back to zero, ready for your next purchase.

It’s always a good idea to have a think about your existing loan products. Consider the features that the product offers and if you’re paying extra for features that you don’t need. A lot of people that have expensive lines of credit don’t actually need them. Generally, lines of credit should be used like credit cards – just for short-term finance (almost bridging finance).

BORROWING CAPACITY

When planning your property portfolio give consideration to how lenders assess your borrowing capacity. Before I expand on this point it’s important to explain how lenders assess external debts (that is, any debts that are not with the lender you are currently dealing with).

Most lenders won’t treat external debts any differently to debts that are with them. For example, if you have a loan for $100,000 (with another bank) on an interest-only basis at 6 per cent (therefore repayments of $6000 per year) most lenders will ignore the interest rate and the fact that the loan only requires interest-only repayments.  Most lenders will calculate what the repayments would be at a benchmark interest rate (normally 1.5 per cent to 2.0 per cent above the standard variable rate) on a principal and interest basis (therefore principal and interest repayments on $100,000 at 8 per cent equals $8800 per year).

However, there are a small number of lenders that will use the actual repayment amount (ie. $6000 per year) and not gross up the repayments.  This can make a big difference. Therefore, the trick is to accumulate debt with the lenders that do not distinguish between external and internal debts first.

Then, once their borrowing capacities are exhausted, you can use the lenders that treat external debts differently. By using these lenders in the correct order you can actually maximise your borrowing capacity.

By the way, I don’t automatically advocate everyone borrowing the maximum they possibly can. You still need to be comfortable that you can afford the debt regardless of the lender’s assessment. Some lenders are very liberal in terms of borrowing capacities and borrowers should not take this as an endorsement to borrow the maximum.

A LOT MORE TO CONSIDER

In this article, I’ve only touched on lending issues and I have intentionally ignored any legal or taxation conse-quences. However, lending structures need to be adequate from a tax- ation, legal and estate planning perspective.

A good mortgage broker or lender might be able to highlight certain issues that may impact upon these areas. However, most mortgage brokers and lenders are not skilled enough or licensed to provide you with professional advice. Therefore, I strongly suggest that you run your suggested loan structures past your accountant, lawyer and financial planner to ensure there are no ugly side effects that you aren’t considering.  It’s always better to be safe than sorry.

PART 3

Next month I’ll finish off with part 3 of this series. The final part will focus on the specific loan structuring issues associated with investing through non-trading trusts  and companies.

There are many issues to consider, so stay tuned if you have these structures in place already (or plan to some time into the future).

Stuart Wemyss is a chartered accountant and director of mortgage broking firm ProSolution.

Email: stuart.wemyss@prosolution.com.au

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