In almost all cases where money is borrowed to buy property, the borrower must first stump up a deposit component. Most mortgage lenders prefer cash deposits of an ideal 20% of the purchase price. This 20% equity makes the loan a low risk for the lender, as they believe this level of lump sum tied-up in the property will motivate the borrower to diligently make repayments so they don’t lose their equity.
But what if you have good income and credit history, but your deposit doesn’t come to 20%? Perhaps you are a first time buyer who has only been able to scrape together 15%? Or in the case of professional investors, you are seeking to limit personal funds invested, perhaps just 10%? A loan with a deposit under 20% represents a higher risk for the lender, yet they still might see you as a worthwhile customer. In this case, the lender could buy insurance to cover their higher risk, called ‘Lenders Mortgage Insurance’ (LMI).
LMI sometimes has a negative connotation associated with it, but this is largely an ‘old fashioned’ approach to purchasing property with borrowed funds. When you look at the true value on offer, LMI is not such a dirty word at all.
WHAT IS LMI?
LMI insures the lender, not you. It covers the shortfall should you default on your mortgage and the property ends up being sold for less than the outstanding loan balance plus some costs. LMI is not ‘Mortgage Protection Insurance’, which covers your repayments should you die, lose your job or become incapacitated..
The beauty for the lender is that the borrower pays for the insurance policy, even though it is the lender who benefits. Borrowers pay the premium for the insurance up-front either from cash deposit funds or more commonly, by adding or ‘capitalising’ it into the loan, meaning you pay it off as you make normal mortgage repayments..
The cost of LMI varies according to deposit size, loan size and type. But here’s a general example: buying a $500,000 property with a $50,000 deposit, resulting in only 10% equity and a loan-to-value ratio (LVR) of 90%, would mean at current rates with a standard loan, the LMI costs could be around $8,000.
TIMING IMPLICATIONS OF LMI
LMI can slow the home loan process because the lender has to have the insurance approved by its insurer. When sourcing a loan with LMI it’s a good idea to have pre-approval from the lender before making an offer on a property. This will ensure that both the lender and it’s mortgage insurer have given the ‘all clear’, as both outcomes will not necessarily be the same due to each party having different criteria.
THE BENEFITS OF LMI (FOR HOME OWNERS)
LMI helps many homeowners into the property market when they have less than a 20% deposit. If the lender is happy with your income and prospects for repayment, LMI allows owners to get a mortgage with a deposit as low as 5% of the purchase price. This is extremely beneficial for first time buyers by essentially fast-tracking their entrance to the market by reducing the time required to save sufficient deposit. Or in the case of down-sizers or relocaters, they may be priced out of the market saving a full 20% deposit, but could still afford the loan repayments of a 90% or 95% LVR.
An important consideration for homebuyers is when using LMI to get into the property market sooner, you have to borrow more. When you add the LMI premium to the higher loan amount, it’s a more expensive loan, which needs to be balanced off with the borrower’s monthly budget, but also your view as to where property prices are headed. If you feel prices are on the rise, getting into the market sooner with LMI may prove to be a money saving alternative to waiting until you have accumulated your 20% deposit.
LMI can be a very good option to help buyers get on the property ladder and stop renting, or move into the suburb (perhaps more expensive) they wish, sooner.
THE BENEFITS OF LMI (FOR INVESTORS)
LMI can be a real facilitator for investors looking to build a portfolio of multiple properties, and is often viewed as a crucial part to their strategy. Because LMI allows a smaller deposit, investment properties can be purchased with a larger loan ratio (LVR), therefore maximising the leverage effect (previously explored last month). Investors will often seek to minimise the amount of physical cash (or equity) used to fund any single purchase, instead opting to use other people’s money to secure assets that grow over time. The cost of the LMI is seen as an expense of “doing business”, and because it is usually capitalised back into the loan amount, the net effect on monthly cashflow is nominal. Further, the cost of the LMI policy is likely to be a tax deduction that can be amortised over the first five years of the investment, therefore further reducing the net cash effect felt on the investor (check with your accountant).
Let’s have a look at how using LMI can supercharge portfolio growth, by maximising the power of leverage to fund multiple properties.
Option 1: no LMI
Assume we are looking at an investment property worth $400,000 and have $80,000 cash funds for its deposit. In reality, you would need more than this to cover the property’s stamp duty and purchase administration costs, but for this example let’s just focus on deposits and growth prospects.
We will put down the full $80,000 as deposit on the investment property and get an investment mortgage for the other $320,000. This results in an LVR of 80% and therefore we will not need to pay for LMI. The repayments for this loan (5%p.a fixed rate, interest only) are $1,333p.m.
Now, add the value of time to the equation and turn the clock forward 10 years and assume an average growth rate of 7% p.a. The investment property is worth $786,860, resulting in $386,000 equity growth at an average of $38,686 p.a.
Option 2: using LMI
However, what if we were to use our $80,000 to fund two separate deposits on two separate investment properties? This process would incur LMI as the loan to value ratios (LVR) would each be greater than 80%, but the effect on net wealth can be considerable.
We will put down $40,000 as deposits on two $400,000 investment properties and get mortgages for the remaining $360,000. The 90% LVRs will trigger LMI to be used, at a cost of approx. $7,000 that will be added (capitalised) to each loan amount. This brings our loan sizes to $367,000 per property, and repayments of $1,529p.m. per loan.
Now, again adding the value of time under the same market conditions over 10 years, each investment property would be worth $786,860, resulting in $772,000 total equity growth at an average of $77,200 p.a.
Assuming in each scenario the rental income of each property was equivalent to the non-LMI monthly repayments ($1,333p.m.), the additional annual expense to fund two properties (using LMI) is $2,352 per property ($1,529 less $1,333 x 12).
However this $4,704p.a. total expense has been able to generate an additional $38,514p.a. in wealth, by unlocking twice the equity growth through acquiring the second property investment in Melbourne.
The downside of the small deposit and higher loan repayments has been easily offset by the portfolio growing across two profit centres (investment properties).
Further, the larger interest repayments will increase the investor’s cash tax deductions, with further potential for a non-cash deduction of the actual LMI policy (amortised over five years). These items increase the potential tax savings and work to reduce the current net cash shortfall of $4,704p.a.
SUMMARY
In summary, LMI can be a great facilitator to either homey buyers or investors alike. When looking at your finances it’s important to understand the true benefit of this ‘expense’, and a mortgage broker will be able to provide further information on the loan structure. Don’t be narrow-minded and look at just the $ expense itself. Rather, look behind the numbers to discover the value or opportunity that is really on offer by utilising LMI to your advantage.
Sources: YBR.com.au