Today’s financial pressures are making it increasingly difficult for many people to enter the property market. The media regularly speaks of how many people are struggling to find enough money for a deposit and the associated purchasing costs, due to insufficient savings. Successive governments have recognised this as a serious issue and subsequently have provided assistance via first homebuyer concessions and grants. This assistance has taken a range of different guises as each government has attempted to make housing more affordable to those looking to buy their own homes – with mixed success.
Investors have not been privy to these types of grants and it has been interesting to watch lenders respond through new product innovations and lending policies – as each attempts to capture greater market share in the lower deposit space. In the past, low or no deposit lending options were the domain of niche non-bank lenders. Although some of these products (and lenders) have ceased to exist and credit requirements have tightened following the GFC, there are still a wide variety of lending options available to help those with smaller deposits.
Times may have changed, but lenders still want that market share! Having these avenues available is positive as it provides a means to reduce the time needed to wait to have your investment property’s deposit ready. If property prices continue to rise, you may find yourself consistently unable to save for the full deposit, increasing the value of any assistance towards getting a deposit saved.
Before signing up for a low deposit loan, though, it is important that you know the opportunities and the pitfalls that this approach can bring. We will take you through two of the most widely used options, hopefully answering any questions you may have along the way.
Borrowing with lenders mortgage insurance (LMI)
In the majority of cases, having less than a 20% deposit (i.e. needing to borrow greater than 80% LVR) means the lender will be required to take out lenders mortgage insurance (LMI). This insurance protects the lender in the event that the borrower defaults on their loan and is there to meet any shortfall if the sale of the security property doesn’t cover the amount outstanding on the loan.
The borrower bears the cost of the insurance premium on the lender’s behalf, with the amount paid dependent on the nature of the purchase. It can either be paid for up front, or is sometimes included (capitalised) into the loan amount so the resulting loan exceeds the original 95% LVR. As a borrower, paying the premium may be off putting, but if you consider that it may help you secure an income-producing asset, it is worth making the commitment.
For example, on a purchase price of $500,000, a 95% loan (or $475,000) may be available, leaving the borrower to contribute a 5% deposit of $25,000. The LMI premium could subsequently be added (or capitalised) to the amount borrowed, resulting in a loan closer to 97%. The amount of the premium would therefore affect the size of your loan, the repayments and your interest costs, but this is not the only consideration.
While lenders may be willing to provide finance at high LVRs, remember that as the amount borrowed against the value of the property increases, so too does the potential level of loss assumed by the lender. The result is that you can expect their credit decision process to be a lot more rigorous around acceptable borrower characteristics such as your repayment capacity, employment and residency stability, savings patterns, ability to honour existing and past debt commitments, as well as measuring the strength of your asset position, relative to your income and age.
Importantly, this “rigour” may be applied not only to the immediate financing request, but also to subsequent financing requests when the mortgage insurer still has a vested interest.
You will also find firm policing of the requirement that at least 3% of the 5% deposit is made up of ‘genuine savings’. So, the stronger the financial case you present, the more likely you will be approved when borrowing with LMI under the more stringent guidelines. Otherwise, you would be advised to consider other options.
Interestingly, some lenders opt not to use mortgage insurance and choose to underwrite their risk differently. Some second tier and non-bank lenders have their own low deposit products, which charge a ‘risk fee’ instead of an LMI premium. Whilst similar in a lot of ways to borrowing with LMI, in some cases aside form the possibility of being cheaper, they may certainly be worth further investigation.
Family assistance
An alternative to paying LMI or risk fees when you have only a minimal deposit is to have others (usually parents or other family members) provide some sort of assistance. As a guarantor, someone external to the purchase may be a party to the transaction by providing additional loan security, often using their own property (providing sufficient equity exists).
It sounds like a great idea doesn’t it? However, you need to consider the implications for the guarantor. They assume some liability for the loan and should things go awry, they must be aware of their obligations under the guarantee. Critically, they must understand how these obligations could potentially affect them and their ability to borrow, should they need to in the future. The guarantor is also placing their property at some risk and must obtain independent legal advice, providing the lender with assurance that they are aware of these obligations and risks.
Understanding the risk-averse nature of many people, some lenders allow guarantors to restrict the amount of their guarantee, thus reducing the amount of risk to which they are exposed. Fortunately, many lenders allow some kind of family or parental assistance, whether in the form of a guarantee or some kind of guarantor home loan – although the terms and structure may differ from lender to lender. Speak to your mortgage broker about the range of loans available and they should be able to help you find the one that works best for you.
An alternative to organising a guarantor is for someone to provide you with a gift towards the deposit gap instead. This can come from funds they have borrowed, proceeds from an asset sale or from their own savings. Again, it is important that the ‘gift giver’ is aware of the risks and disadvantages that may result from the gift tying up their funds from other possible uses.
There’s also still a need to check that, while the gift may be enough for the deposit, it may not help the borrower fulfil the actual savings requirement of the loan. Ultimately, adopting either of the guarantor or gift strategies may help reduce the actual borrowing requirement, making loan repayments more manageable to service.
Another alternative is for family members to borrow jointly with the original borrower. Using any available equity they can bring to the transaction, they can purchase a property as joint tenants ‘in common’. This assumes that the family member has capacity to co-borrow and the desire to be a party to the purchase in this manner. Whilst a significant help to the original borrower, this approach also makes them more liable for the loan than if they were a guarantor only.
What to consider when taking a low deposit loan
Regardless of deposit size, maintain your discipline. Using a low deposit loan means you no longer need to save for the full 20% deposit, but be sure to build up some reserves to cover any downturns. Consider what type of home you are buying. High LVR loans are not necessarily the best option for properties in need of renovation work, as the extra outlay to make them habitable could be a cost you can’t afford.
Knowing your potential to be exposed to risk as part of your new loan is vital. When making principal repayments at the start of the loan term, much of the repayment will go directly to the interest component. In stable market conditions, you could face being overextended on a property only holding its value at best and if property values fall, you risk having negative equity in the property.
Make sure you can afford the loan. You must maintain a disciplined approach, whether building up your redraw facility or putting funds in an offset account. Every time you use redraw or spend from the offset account, you are actually reborrowing money, so be careful.
Consider the impact on your borrowing capacity. If you have to service a higher existing debt load, it can impact your ongoing borrowing capacity. This may deter a lender from making finance available if servicing becomes tight. Low Deposit Loans can work when more funds are available. They can be an appropriate loan option even if a 20% deposit is held. For example, they can be used to secure several purchases at once, rather than using the full deposit on a single property.
The right type of low deposit loan for you is one that is aligned to your future goals, as well as your current and future personal circumstances. At Zinger Finance we believe that a low deposit loan, particularly the right type of low deposit loan, can be a great lending option. Make sure you speak to a qualified professional mortgage broker and/or financial advisor before making any decision.
Graham Turnbull (graham@zingerfinance.com.au) is a strategist with Zinger Finance
