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How you structure your loans can have a big impact on the tax you pay, your risk, your ability to build wealth, your cash flow and your general financial strength. Efficient loan structuring is a commonly overlooked and rarely understood topic but that’s not to say it’s overly complex. Like anything, you don’t know what you don’t know until you know it. Many people tend to carry a reasonable amount of (investment) debt throughout their working life so it’s especially important for you to ensure your mortgages are your servant, not your master.
This article will highlight some of the common strategies and structures that are useful for investors to consider employing. You can use it as a bit of a checklist to see if you are optimising your loan structure. But a word of warning – this article obviously does not take into account your circumstances so please seek professional credit and/or tax advice before making any changes to your loans.
Always borrow the maximum and use an offset
The first thing to be very mindful of is that you typically only have one opportunity to crystallise the maximum tax deductible loan in respect to a property – that is, when you first purchase it. You cannot contribute cash and borrow a lower amount when you purchase a property and then subsequently increase the loan later on (as the purpose/use of the additional funds will determine whether the loans are tax deductible or not). The second thing to keep in mind is that time and time again it is demonstrated to me (through dealing with hundreds of clients) that there is one thing that doesn’t change in life and that is change itself. Therefore, you will do yourself a great service to structure your finances to give you as much flexibility as possible.
Let me explain using an example; Dr Smith purchases an investment property for $500,000. He has repaid his home loan and has no other debt. He has $190,000 of cash savings to contribute to the investment. He has two options; ignoring costs for this example, he can borrow what he needs being $310,000 ($500k less $190k cash) or he can borrow $500,000 and deposit $190,000 in a linked offset account. The latter option won’t cost him any more as the bank will only charge interest on the next balance of $310,000. However, Dr Smith can still access the $190,000 cash savings at any time. For example, if a few years after purchasing the property Dr Smith decides to undertake some renovations to his home costing approximately $100,000, he can withdraw this amount from the offset. Of course, because the balance in the offset has reduced, his interest bill will increase but all the interest will be tax deductible. If he had not have structured his loan with an offset, he would have had to borrow the $100,000 for the renovations and the interest on that loan would have not been tax deductible. In summary, it is nearly always the best approach to borrow the full cost of a property and deposit cash in the offset.
Always interest only
In keeping with the previous sub-heading, this tip also relates to preserving future tax benefits and maximising your flexibility. Structuring your loan repayments as interest only (and not principal and interest) provides the following benefits:
- It allows you to accumulate all surplus cash in the offset instead of reduce the loan principal. That is, it preserves the loan principal at its original value which might be important for future tax benefits (similar to the above strategy – “always borrow the maximum and use an offset”). This even might be appropriate for your home loan as your home may become an investment property one day
- It reduces your financial commitment to the lowest level. The benefit of this is twofold. Firstly, it minimise your risk in case of a change of circumstances such as a temporary reduction in income. Secondly, it allows you to direct your surplus cash flow as you see fit from time to time. For example, an investment opportunity might arise that necessitates you to only pay interest only on your home loan for a few months.
Be careful to not give the bank too much security. A property’s title is better held in your possession than the banks. The rule of thumb is to try and keep your loan to value ratio at or around the 80% of the securities value. This will still allow you to get the lowest rate whilst not giving the bank any more security than they need.
A common example of ‘giving the bank too much security’ is where a client might have a small home loan for say $200,000. The client then purchases an investment property for $550,000 and borrows $580,000 to fund this purchase (i.e. including stamp duties). The bank will often hold the client’s home and the new investment property as security. However, if the client’s home is worth more than $900,000 (which is often the case), the bank doesn’t need to take the new investment property as security. The home in itself will provide plenty of security for the home and investment loan.
The advantages of holding onto the title are that you can take a clear title to another lender to get a new loan and your existing lender does not need to know anything about it. Also, when it comes to selling a property without a mortgage (i.e. clear title), it is an easier process and you have full control over how to use the sale funds (whereas if the bank holds the title they can force you to use all the funds to repay debt).
Putting all your eggs in one basket is rarely a prudent thing to do in many (all) things in life including dealing with banks. There are many advantages with diversifying lenders including:
- Sometimes a lender knows too much about you and therefore has too much control over your personal, business and investments. Banks are good servants but bad masters
- It is possible to better manage (maximise) your borrowing capacity by using multiple lenders – of course it’s still important to borrow within your safe limits
- Banks are less like to get “lazy” if they know they don’t have all of your business. It keeps them on their toes and prevents them from becoming complacent
- Bank property valuations commonly vary significantly from one bank to the next. Having a relationship with two or more banks (or better still, a mortgage broker) will allow you to maximise your borrowable equity (i.e. how much you can borrow against a property)
- Fixed rate – you have more than one lender to choose from without needing to refinance.
Cross-securitisation is where any one loan uses more than one property as security. A simple example of cross- securitisation is where you have an investment loan secured by two properties: your home and the investment property. Here are the top 3 reason why you must avoid cross-securitisation:
- Does not allow you to maximise borrowable equity (i.e. lack of control over valuations) – It is not by chance that this is my first point as maximising your borrowable equity is critically important as the sooner you invest, the more money you make over time (because of compounding capital growth). If you avoid cross-securitisation you can determine which properties to revalue and when. It is likely that it won’t make sense to revalue all your properties at the same time (as the amount and quality of recent sales of comparable properties often determines if it’s advantageous to revalue a property or not. If there are not many comparable sales, try and defer any bank valuations). If your loans are cross-securitised, the bank will want to revalue all the properties that secure your mortgages – not just the ones you want to revalue. Consequently, you might get a mixture of higher and lower valuations which may negatively impact on your overall borrowable equity (as the lower valuations might more than offset the value of the higher valuations).
- Tying you to particular lender and reducing your flexibility – If all your mortgages are cross-secured your banking can become very entangled and it may prevent you (or make it very costly/difficult) to take one property away from your existing bank to get a better deal. You may want to use a new lender because, for example, it’s offering a special (fixed) rate or perhaps it has a higher borrowing capacity and you have fully utilised your existing banks borrowing capacity. However, you may not want to refinance your whole portfolio. Having all your properties separately secured gives you more flexibility as you might be able to refinance one property to the new lender. This will probably help you maximise your borrowing capacity too (borrowable equity).
- No control over sales proceeds – If your mortgages are cross secured, the bank can control any and all sales funds (if you sell a property) and force you to contribute it to repaying debts. However, if there is no cross-securitisation, the bank can only demand repayment of the mortgages secured by that property only. It is then up to you what you do with the balance. This is important as you might be selling property to realise cash reserves and allowing the bank full control over your money negates the benefit of selling in the first place. This is an important risk management point as many investors rely on the assumption that if things go pear-shaped, they can sell and walk away with cash. This might not be possible if you are cross-securitised.
Don’t mix business with pleasure
Sometimes having your business (for self-employed clients) and private banking with the one bank might seem convenient. It could very well turn out to be very convenient and you may not run into any trouble. However, I have seen plenty of situations where this hasn’t worked out well for clients. The problem with this is that the bank has too much control and they know too much. For example, if you have a dip in revenue for a few months and then apply for a personal investment loan, they might start asking questions. Instead, if you separate your business banking from your personal banking, you control the amount of information each side has. This might be less important when things are going well, but becomes a lot more important if your financial situation becomes a little more complex or changes. In hindsight, it’s rarely worthwhile to use the same bank for business and personal banking.
To a much lesser extent, the same can be true for personal and investment lending too. That is, consider using different lenders.
Stagger fixed rate expiry
Most investors will be long term borrowers. They will typically have mortgages for most of their lives such as investment mortgages. In fact, it’s good to come to terms with this – i.e. its important (efficient) to hold a healthy level of good debt (tax deductible debt) for most of your lifetime. As such, it makes sense from time to time to fix mortgage interest rates. It’s good interest rate management to stagger the expiry of fixed rates. For example, it might make more sense to have some of your mortgages on a variable rate, some fixed for 3 years and some fixed for 5 years. This gives you more flexibility to review your interest rate management (i.e. fixed versus variable) at regular intervals.
It is impossible to make this article an exhaustive list of loan structuring tips and strategies but hopefully it gives you a taste of what we consider when working with clients. The upshot of it is; you don’t know what you don’t know until you know it. Therefore, like with many financial matters, it makes sense to obtain professional credit advice from an experience mortgage broker/lender when establishing your loans. Interest rate and fees are important to consider but often, optimising the loan structure can add a lot more value.
Questions or comments? Email Stuart Wemyss – click here.