Property investment 101: Loan options for first home buyers

Experts strongly advise investors to shop around and consider the different mortgage loan features, including home loan rates, loan features fees, repayment options and other associated property costs, before ultimately deciding which type of loan to use as you make your first step on the property ladder.

Borrowing to invest

There are different types of home loans and features available to investors depending on their financial standing as well as their investment goals.

First-time buyers, in particular, may enjoy the benefits of multiple incentives and assistance. Being able to determine how the available financing options will fit your budget and financial circumstance at a given point is key to thriving in the ever-changing property investment landscape.

Credit score

A potential borrower’s credit score serves as one of the primary basis of banks and lenders in determining their borrowing capacity.

The credit score is largely influenced by loan repayments and credit card repayments, with late payments, defaults and infringements inflicting a negative effect. Personal debts, bankruptcy, jail time, judgments and court writs, credit card balance and limit as well as your partner’s credit score, if applying together, can also affect the credit score.

On the other hand, the inability to pay tax on time or a credit card balance from a decade ago, as well as the failure to pay the full monthly credit card balance, will not affect the credit score. Salary, bank account balance, the neighbourhood you live in and level of education also has no effect on the credit score.

While there are specialist lenders who will service people with bad credit, a poor credit score generally makes it harder for investors to be approved for loans in the future, especially considering the tighter lending environment in today’s property market.

Borrowing power

Once a good credit score is proven, investors may start to determine their borrowing power or serviceability, which essentially gives them an idea on how much banks and lenders will be willing to let them borrow for their property purchase.

Borrowing power will depend on several factors, including income, financial commitments, current savings and credit history. Lenders may also consider annual income and monthly expenses, the current interest rate, the type of loan being applied for, as well as the type of repayment and loan term chosen by the investor and the estimated monthly repayments that they will be making. Employment status and genuine savings can also affect their borrowing power.

Most lenders will ask potential borrowers to provide official documents to prove their income. In general, projected repayments should not be more than 35 per cent of their gross income.

Among the different methods that lenders use to determine your borrowing power or serviceability are:

• Net surplus ratio: Factors considered for calculations are current debt, proposed debt and living expenses.
• Debt servicing ratio: Divides income into three – a third to tax, another third to living expenses and the remaining third to mortgage repayments. It does not consider negative gearing and living expenses.
• Surplus or uncommitted monthly income: Subtracts all monthly expenses from gross monthly income to determine available income.

To determine the amount of loan that may be provided, consider the size of deposit, the loan-to-value ratio (LVR) and other lending guidelines. Depending on the chosen bank or lender, the investor may be able to get 80 to 100 per cent of the property value in home loan.

The ideal maximum purchase price can be determined by the following formula:

Available equity (current value of home x LVR - total mortgage) + savings/entry costs (based on percentage of deposit and 5 per cent buying costs) = maximum purchase price

Smart Property Investment’s borrowing power calculator helps determine one’s borrowing power and gives a budding investor an insight on how an investment property may affect their day-to-day expenses by providing a breakdown of the possible monthly repayment amount.

Mortgage loans and features

Well-structured mortgage loans will be the foundation of a growing portfolio, which is why it is important to obtain loans and loan features that match the investor’s needs and long-term goals, capabilities and limitations. Loans should be able to weather the changing economic conditions, fluctuating property markets and unexpected life circumstances.

Experts encourage “shopping around” before ultimately making a decision. Budding investors must consider all loan products offered by the lender, the processes they follow from application to settlement, their interest rates and how all their offerings can meet their needs and help them achieve your goals.

Some of the most traditional home loans include:

1. Principal and interest loans (P&I)

P&I loans allow investors to decrease the principal amount borrowed and pay the interest on your loan. This type of loan is considered the most straightforward way to fully repay a loan within 25 to 30 years. Investors can add features such as redraw facilities or offset accounts for additional fees.

Estimate the amount of principal and interest to be paid regularly as well as the length of time needed to pay down the loan fully through Smart Property Investment’s Principal and Interest Calculator.

2. Interest-only loans (IO)

IO loans will allow investors to make repayments that cover only the interest on their loan for a set period, while the principal amount borrowed can only be paid down through extra repayments. Through this type of loan, they can make lower repayments during the first few years of the loan, enjoy maximum tax deductions and reduce their tax payable. The loan will revert back to the standard P&I loan when the interest-only period is over.

Despite the lower repayments, IO loans are usually considered a more expensive option in the long run. Interest rates on IO loans are usually higher than the standard P&I loans. Moreover, since the borrower is continuously paying interest on a principal that is not decreasing, the repayments are likely to increase and they will have less time to pay off the outstanding debt once the loan reverts back to P&I. By using IO loans, they may also have limited ability to build equity unless the property increases in value significantly within the set interest-only period.

Investors can mitigate risks by preparing themselves financially for the loan switch. Gradually increase loan repayments as the end of the set period nears, reassess investment budget and consider negotiating for interest rate reductions or switching home loans altogether.

Meanwhile, the most basic home loan features are:

1. Variable interest rates: Variable rate home loans are considered as the standard property loan which allows investors to make repayments depending on the fluctuations of the official cash rate. Lenders can also make independent changes depending on their own regulations. While this option could be a challenge for budgeting, investors can mitigate risks by availing attractive loan features, including the ability to make extra repayments or accessing redraw facilities and offset accounts. Being one of the most flexible options in the market, this type of loan also offers easier and affordable ways to switch loans.

2. Fixed interest rates: Fixed rate home loans allow investors to set the interest on their loan for a fixed period of around two to five years, therefore avoiding the risks of fluctuating interest rates that can influence their repayments. Once the fixed period ends, the loan will revert to a standard variable rate home loan that matches their loan purpose and repayment type. Among the most important benefits of this type of loan is being protected from interest rate hikes, which will allow the borrower to stick to their investment budget and plan their finances accordingly. However, when interest rate drops, they will be missing out on the chance to make lower repayments. Investors may also have limited access to most loan features.

3. Split interest rates: Split home loans are, essentially, part variable and part fixed. This structure allows investors to manage the risks of fluctuating interest rates while enjoying the benefits of different loan features, which makes it most beneficial during periods of economic uncertainty. The allocation of interest rate model could be anywhere from 50/50 to 20/80 and 60/40 or whichever matches the needs, capabilities and limitations of the investor. While the borrower gets the benefits of both variable and fixed rate home loans, they also get both of their risks. Moreover, two-in-one loans may also mean double fees, from setting up and managing the loan to discharging.

4. Capped interest rates: Capped home loans allow investors to put a ceiling on the interest rate for a fixed period, thereby protecting them from significant rate hikes while still letting them retain the ability to benefit from rate drops. Rate lock fees, which typically goes for 0.15 per cent of the loan amount, may apply. Interest rates could also be higher than the standard variable rate. When the fixed period ends, the borrower can recap the loan or choose between the standard variable rate home loan or the standard fixed rate home loan.

5. Redraw facilities: As it allows the borrower to make additional payments directly into their home to reduce both principal amount and the overall interest charged, redraw facilities also give them the ability to redraw any amount in excess of the minimum repayments as scheduled. By getting this feature, they pay off the loan and pool spare money at the same time. However, it may require a minimum amount to be redrawn as well as fees for withdrawal. If the money redrawn is for non-investment purposes, it will cease to be tax deductible. Redraw facilities also usually take longer to transfer funds and may be subject to other limits depending on your chosen lender.

6. Offset accounts: Unlike redraw facilities, offset accounts only reduces the interest-bearing balance of the loan as it allows you to deposit money on the account and credit it against the interest payable on the loan. A 100 per cent offset account credits balance with the same interest rate charged on the loan while a partial offset account will require the borrower to pay a higher interest rate on the loan than they receive on their savings. This feature can be treated as an everyday transaction account since they can access their funds through commonly available devices such as ATMs and there is usually no limit on the amount that can be withdrawn. Any withdrawal will have no effect on the tax deductibility on their interest expense.

7. Line of credit loans and salary deposit: Line of credit loans gives the borrower the ability to have their salary paid into an account that pays their bills and settles other expenses, all while allowing them to spend up to a certain fixed credit limit. They will need to repay the loan in full on a specified date. On the other hand, salary deposits will allow them to have a part of their salary paid directly into their loan account, thus helping them minimise the stress of keeping up with repayments.

8. Portability: Loan portability accommodates the transfer of an existing loan to another property if the borrower decides to move houses before the mortgage is fully paid, thus allowing them to avoid exit fees and new loan application fees and letting them keep existing features on their loan. This feature will have them transacting with the same lender in the same loan structure.

9. Mortgage repayment holiday: As the name suggests, this feature will allow the borrower to temporarily stop making mortgage repayments. However, interest charges will continue to apply within the duration of the “holiday”.

10. Extra repayments: The extra repayments feature will give the borrower the ability to fast-track the payment of their debt. Depending on the lender, this may come with certain fees and restrictions.

Finding a lender

Gone are the days when borrowers have to travel far or be passed around financial managers to obtain a home loan.

Virtually every bank across Australia now offers a variety of options for home lending. Even independent lending institutions, building societies and credit unions have also seen a significant rise in activity across the states and territories.

To avoid being overwhelmed by all the options, have an idea about the type of loan you want to use and the loan features you want to have and set a standard for your lender—both personal and financial. Can they work around your budget? Will they commit to maintaining an honest and open relationship with you?

Experts advise against making rash decisions when picking a lender as they can essentially make or break your investment journey.

Instead, take the time to ‘shop around’. Let the lenders’ home loan specialists give a clear explanation of their loan products, the processes they follow from application to settlement, their interest rates and how all their offering can meet the needs of the borrower and ultimately help them achieve their financial goals.

Budding investors can also engage mortgage brokers or make use of online resources such as Smart Property Investment Loan Comparison calculator to help them compare loan products and features.