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You don’t have to become a financing genius to be a great property investor but in addition to finding a great finance professional, you should have at least a basic understanding of how the finance aspect of property investing works.
The following five rules are basic concepts you will become very familiar with over the course of your property-investing career. They will, in fact, become second nature over time.
1. Other People’s Money (OPM)
Yes, you can buy an investment property using other people’s money. In fact, you SHOULD do just that! Well, mostly other people’s money – you may have to kick in at least 10% to 20%, but that just means you’ll have more equity from the start, right?
Leverage can greatly improve your returns because it expands your buying power. For example, let’s say you’ve got a property that is valued at $300,000 and you’ve got a $120,000 loan, giving you $180,000 in borrowable equity.
Now let’s assume you want to purchase an investment property for $350,000, however, you don’t have the cash to put down for the deposit. Here’s where leverage comes into play.
Equity = ($300,000 x 80%) – $120,000 = $120,000
Investment property = $350,000
After using leverage to purchase your investment property the numbers will look something like this:
Existing loan = $120,000 + $380,000 (purchase price PLUS costs) = $500,000
So then the formula is
New borrowing = Existing loan + Investment Property Value + Costs
Loan to Value against investment property = Total borrowing/property value x 100
$380,000/$350,000 = 109%
Value of property secured = $650,000 ($300,000 + $350,000)
Therefore the new total LVR = $500,000 (total borrowings)/$650,000 (total security) = approx 77%
Total bank held security = existing property + new investment property
Total bank security = $300,000 + $350,000 = $650,000
Total loan to value ratio = total borrowing/total security x 100%
Total loan to value ratio = $500,000/$650,000 = 77%
As you can see, despite the fact that the borrowings on the new investment property are 109%, the equity you have in your home will reduce the overall LVR, keeping the bank happy as they will have plenty of security for their interests.
2. Interest-Only Loans
Interest only loans are a popular choice among property investors and for good reason – they’re a smart way to manage your money! Why?
Payments for an interest only loan will always be smaller than one that includes both principal and interest. This is an important factor, because you always want to have plenty of “wiggle room” in your payments for unexpected life (and market) events.
When you have the extra cash you can make principal payments whenever you choose and if you have a need you can take back your principal payments because YOU own those repayments. In a principal and interest loan not only are you locked into a higher payment, the bank owns all of your repayments, eliminating any possibility of taking back monies you’ve paid in.
3. All monies clause
A common clause you will find within many loan documents is the “all monies” clause. In essence, this clause allows your bank to review – at any time – all loans you have with them. What this means is that if the bank believes your debt has grown too high or that your properties’ values have declined, putting them at a greater risk, you can be required to provide the lender with additional funds.
This clause also gives the bank the authority to force you to use any of your other properties as security to provide the additional funds in order to re-secure the loan. This will put a SERIOUS HURT on your ability to move forward as a property investor.
An example of an “all monies” clause is shown below:
4. Cross-securitisation – avoid it!
Avoid cross-securitisation of your properties at all costs. Each time you seek funding your lender will review your position, opening up the possibility that your lender will require additional funds because your risk profile (according to their internal guidelines) will have changed.
To avoid this situation, arrange finance with different lenders for each property you purchase.
Remember. It’s vital that you read and understand the terms and conditions of the bank’s contract. Keep an eye out for the “all securities” clause which is bank “lingo” for cross-securitisation. This clause allows the bank to use one or more of your properties as security, which can put a serious roadblock to your property investing career.
5. Get the “cash flow thing” right
Did you know that only 3% of Australians own 3 or more properties? Why is that? Cash flow of course.
Although most Australians know that property investing is one of the best ways to create wealth, they are afraid of paying the shortfall. One of the best things you can do is to create a good buffer for yourself.
Let’s say you have $100,000 in equity. Set up a buffer for the shortfall that will last you about two years’ time. Don’t think of this as losing money, as capital growth should be more than what it’s costing you to keep the property.
One of the best things you can do when it comes to finance, however, is to enlist the aid of a finance specialist who can help guide you through the process of obtaining the right loan for your property purchase and who can advise you as you continue to grow your wealth.
If you’re stuck in your property investing journey, why not enlist the aid of experienced property professionals to help you along the way. Stop by one of our complimentary Property Investor Nights and find out for yourself what so many property investors have learned – investing is better with a mentor!