Finance advice
Kevin Lee

Investors FYI - How the banks work

By Kevin Lee

In the movie 'Wall Street: Money Never Sleeps' Michael DouglasDouglas, QLD Douglas, QLD sums it up perfectly - today's society is ruled by debt and banks are no exception.

Blogger: Kevin Lee, founder, Smart Property Adviser

The Fractional Reserve System (which all banks operate on) is one that allows banks to borrow your funds in order to lend it someone else (technically speaking).

Here's how it works; bank A's fractional reserve rate is 10% and you give them $100,000 of your money to place into a savings account, they're obligated to place $10,000 in reserve ( out of your $100,000) and lend out the remaining $90,000.

Obviously when they lend out the remaining $90,000 they will charge interest. Let's say Bank A pays you 2% interest for saving with them, and charges 6% interest on the $90,000 they lend out.

Over 12 months the bank will pay you (the saver) $2000 or 2% interest for your $100,000 deposit. However the borrower with the $90,000 loan will pay the bank $5,400 interest. So the bank makes money from lending your money to others.

Due to this banking regulation, all banks must ensure their borrowers can repay the funds borrowed funds, plus interest, so they have what's known as a 'risk grade' for different assets.

Here's a tip for all investors: if you're smart about it, you can use this information to identify which asset class is the "safest" place to put your hard earned cash.

Just follow the banks' collective "lead" in relation to where they perceive risk is and where their comfort zone sits.

Remember that our banks and other lenders are in the business of making money by lending money - they're experts at risk analysis. They have to be if they want to get their money back!

So they assess their lending and interest rate on offer using a simple explanation: 'rate for risk'.

Which translated into English means: the riskier the security, and/or borrower and/or business venture then the lower the percentage (lower LVR) we will lend you against that security and the higher the interest rate we'll charge you will be.

How do you follow their lead? By identifying the Loan to Value Ratio (LVR) that your bank will lend against each of the three primary asset types.

Remember - the riskier the bank perceives the asset to be, the lower the LVR they'll be willing to lend against it.

It's interesting that the major banks and other lending institutions will lend up to 95% against prime residential real estate at 3 year fixed rates as low as 4.79%. Some variable rates are now also around 4.80%. These are historically low rates!  However these same lending institutions will lend a maximum of 65% against the value of prime commercial real estate and depending on your risk assessment as a borrower, the interest rate on this commercial property will most likely be between 6.00% and 8.5%. NB - some lenders will still lend up to 75% on commercial property at a higher interest rate: usually an extra 1%.

What about the Stock Market? Everyone knows someone who's made a killing in the stock market over the past year, don't we. Really?

Well here's what the Big Four banks think of shares as security for a loan.

When you borrow to purchase shares and use the shares as security for the loan it's referred to as a Margin Loan. For the uninitiated the maximum LVR they're willing to lend to can be a shock to the system. In fact most shares are not acceptable as security for a Margin Loan - especially if you're purchasing shares in just one company. That's considered to be even more risky.

For example - buy 20,000 Telstra shares on their own and CBA will lend you just 65%. Buy them as part of a portfolio and they'll lend to 75%.

Guess what CBA thinks of CBA shares as the security for a loan - exactly the same. 65% for stand alone shares vs 75% if they're held inside a portfolio.

Want to splash out on some mining shares do you? Maybe you might want to rethink that: shares in many of the listed mining, energy & resource companies will only get a 40% LVR inside a portfolio and zero as a stand alone purchase.

And if you're borrowing on a Margin Loan to purchase shares - be prepared for the interest rate to be upwards of 9%.

Remember - the bank's #1 job is to make money and hand in hand with that is their assessment of risk.
So, what does this all mean for you?

Simply this: If you want to invest wisely and safely, you would be well advised to follow the Banks' lead. If they perceive residential real estate as being the asset class with the least risk, then you should consider residential real estate as your primary investment choice.

Unfortunately not every residential property is a smart investment opportunity. If you don't know how to identify the right properties, you run the heavy risk of investing in a property that is negatively geared, will cost you money and will restrict you from growing your portfolio. But, a smart property adviser can give you the criteria for finding cashflow positive properties that will work for you and your portfolio.

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About the Blogger

Kevin Lee

Kevin Lee

Kevin Lee of Smart Property Adviser is regarded by many as Australia's most trusted property investment adviser. Since 1999, Kevin's been the go-to-guy for people when they need honest finance and property investment advice and guidance.

Kevin hosts a regular Investors' Boardroom and investors from around the world fly in to Sydney to attend. More information is available at www.smartpropertyadviser.com.au

FROM THE WEB

podcast

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In this episode of the Smart Property Investment Show, Dominique Grubisa joins host Phil Tarrant to share her personal story which saw her hit rock bottom with excessive debt during the GFC.

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Dominique unpacks how, by relying on her background in law, she was able to overcome that debt and in doing so develop a unique investment strategy which she believes many can utilise today.

Dominique discusses distressed properties, and how she goes about finding them in order to buy property well below market value. She shares the process of identifying distressed properties as well as the controversy surrounding this buying method.

If you like this episode, show your support by rating us or leaving a review on iTunes (The Smart Property Investment Show) and by following Smart Property Investment on social media: FacebookTwitter and LinkedIn.

If you have any questions about what you heard today, any topics of interest you have in mind, or if you’d like to lend your voice to the show, email [email protected] for more insights!

RELATED AREAS OF INTEREST:

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More than just bricks and mortar, experts often regard property investment as a ‘game of finance’. As such, a good finance strategy can lead any investor to success.

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Tune in to the latest episode of Property Showcase, the podcast with the inside track on the products and businesses that will help turbocharge your portfolio, maximise returns and make your overall investment experience seamless and stress-free!

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To hear more about these services, make sure to tune into this episode of Property Showcase!

 Make sure you never miss an episode by subscribing to us now on iTunes!

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    In this episode of Property Showcase, Michael Beresford joins editor of Wealth James Mitchell to unpack why recent political changes are not reason for concern for Australian investors.<\/p>\r\n

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Many investors who would have been successfully approved for finance last year are struggling now to either begin or continue their property investment journey because of the current financial climate.

In this episode of the Smart Property Investment Show, broker John Manciamelli and Momentum Media director Alex Whitlock joins host Tim Neary to discuss how APRA changes and the royal commission have resulted in a tighter lending economy and what that means for Australian investors.

They discuss what traps investors should avoid if they are trying to obtain finance, the four key growth drivers in a property market and unpacking trust structures while revealing one type of trust that you should miss.

If you like this episode, show your support by rating us or leaving a review on iTunes (The Smart Property Investment Show) and by following Smart Property Investment on social media: FacebookTwitter and LinkedIn.

If you have any questions about what you heard today, any topics of interest you have in mind, or if you’d like to lend your voice to the show, email [email protected] for more insights!

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Lessons from a falling market
APRA investor measures have ‘run beyond their usefulness’: industry body

 

AREAS MENTIONED:

Hobart
Bondi
Deception Bay

 

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More than just bricks and mortar, experts often regard property investment as a ‘game of finance’. As such, a good finance strategy can lead any investor to success.

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Getting finance approved in this tightening lending environment

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