So, you’re thinking about an investment rental property, hey?
Choosing the right loan can be just as difficult as choosing the right property.
You might not be thinking “What type of loan do I need?” and “What’s the minimum deposit required on an investment property?”
Well, in this article I’m going to cover all of that and more; including:
- Home loans vs. Investment loans
- How investment loans work
- What you need to know before getting a loan for an investment property
- The investment loan checklist
- The information you need to get from your lender
It’s time to turn the television off, sit your kids in front of the iPad and learn about what it takes to purchase your first investment property.
Home loans vs. Investment loans
Investment loans are actually very similar to home loans. However, from a lenders perspective there is slightly more risk because your ability to fund loan repayments is often partially dependent on a tenant paying you rent. To compensate the lender for this additional risk, there may be a higher interest rate charged.
But in saying this, the investment loan will also provide benefits to you as an investor. This is because the interest paid on the loan is tax deductible, reducing the effective after-tax interest rate.
The interest on a regular home loan is not tax deductible.
For example, a standard home loan may have an interest rate of 5% p.a. This means, on a $300,000 loan, your repayments would include an interest component of $15,000 each year.
Let’s say you also had a $300,000 investment loan with an interest rate of 6% p.a. This would mean that your repayments on the rental property loan would include an interest component of $18,000 per year – slightly higher than your home loan.
However, because interest on investment loans are tax deductible, the after-tax cost of this interest on the loan would only be $12,150 if your marginal tax rate is 32.5% – reducing the effective interest rate to 4.05% p.a. – once you have lodged your tax return and claimed a tax deduction for the interest.
There are a few other things you need to know about investment loans before you go any further, so let’s take a quick look at a few of these things now.
How Investment loans work
Before you even start thinking about where you want to buy or how many rooms your investment property will have, you need to start saving for the down payment for your rental property, and start saving yesterday.
If you’re in a rush to buy, you have the option to provide the minimum amount required, but I recommend staying the course until you have reached at least 20% of the value of the property. This will provide you with benefits like:
- A lower mortgage
- Less interest charged
- No Lender’s Mortgage Insurance (LMI)
The last point mentioned above is a big one because, depending on your situation, LMI may cause further financial burden that, with patience and hard work, could have been avoided.
LMI is a premium that you pay to the lender for not having a 20% deposit because they, in turn, need to accept more risk. LMI could be in the form of a lump sum added to your home loan capital, or could be a fee additional to your standard repayments.
As you are reading this, I can sense that the 20% figure is causing a number of physiological reactions:
- Sweaty palms
- The desire to pull your hair out
- A clenched jaw
- Clenched fists
Ok, so let’s answer the question that’s just dying to escape your lips:
“What is the minimum deposit required on an investment property?”
If 20% is something that you feel isn’t possible, and won’t be possible for a while, you can go for the minimum deposit required on an investment property which, depending on the lender, could be 5% of the purchase price. But to make things a little easier on your life I suggest you try aim for a minimum of 10% deposit for your investment mortgage.
Some of you might be wondering, “Chris, can I get a business loan to buy rental properties?”
This question has a two-part answer:
- But, it’s usually not ideal
Applying for a business loan is generally not advised for this situation, as this type of loan will likely come with a higher interest rate and you will also need to prove to the bank that your “business” (the investment property) will be able to service the loan repayments. The lender will generally assess the benchmark rate at least 3% to 4% higher than a normal investment loan to cover themselves from fluctuating interest rates – this means you will be unnecessarily paying out excess amounts of your hard-earned cashola.
“Can I get a second mortgage on an investment property?”
Yes, you can get a second mortgage on the investment property, but again, try not to exceed total LVR of 80% total property value. LVR stands for the Loan to Value Ratio, which is the loan amount divided by the properties being borrowed against. For example a $400,000 loan on a $500,000 worth of properties will equal an 80% LVR.
What you need to know before getting a loan for an investment property
Interest rates on rental property mortgages
Just like normal home loans, investment loans allow you the option of choosing between either a variable or fixed interest rate.
The variable rate usually comes with added options, like the ability to redraw, but, as much as I hate to admit it, a better strategy for investors is often to opt for the fixed interest rate. Despite this previous article I have written ‘Why you should NEVER fix your home mortgage’.
But in this case – owning an investment property – the fluctuating nature of the variable interest rate makes it difficult to create and plan for future investments. This is due to the lack of consistency regarding the amount you are obligated to fork over when each repayment is due. A fixed rate ensures regular payment amounts allowing for accurate budget estimations.
Another thing to consider when deciding on a fixed or variable interest rate is the lease periods for your future tenants. A variable rate may cause financial difficulty when longer-term leases are signed. That is, you wont be able to raise the rent to correlate with fluctuating interest rates. The fixed option will remove any volatility and unexpected financial stresses for the fixed period.
Types of loans
- Interest only
- Line of credit
With a normal home loan, you are expected to pay back a percentage of the principal (the original loan amount) plus interest at each repayment date.
With an interest only loan, you are only required to repay the interest amount due for the duration of the interest period, unless you volunteer to make additional payments to reduce the principle.
This provides the benefit of lower monthly repayments, plus you are able to claim the interest repayments as a tax deduction. However, you need to be aware that your loan balance will not reduce with an interest-only loan. It is almost like you are paying a monthly fee for the privilege of having access to the borrowed amount.
Line of credit
This type of loan is great for those of you who already own a property. Using the equity you have built up in your existing property as a form of security, allows you to apply for a line of credit loan.
No specific repayments are required. Interest is simply calculated on the fluctuating loan balance each day. The loan balance fluctuates based on contributions to the line of credit or withdrawals from it, plus any interest accrued.
The investment loan checklist
Remember, signing up for an investment property mortgage is a big deal, you need to be absolutely sure about a number of things before you proceed.
Use this quick-check investment property mortgage checklist to make sure you have all your bases covered.
- My deposit is:
- A: The minimum deposit required on an investment property loan
- B: 10% of the value price
- C: 20% of the value price
- I can afford to borrow $____________
- I can afford to payback each month $____________/mth
- The current mortgage rates for rental properties is ____________% p.a.
- Get loan comparisons from lenders
- Choose the loan features and type
- Is this really what I want to do?
- What would happen if I lost my job?
- Have I thought about life insurances?
The information you need to get from your lender
Don’t rush into a deal with the first lender who bats a seductive eye at you.
Make sure you shop around and evaluate which deal is best for you, your situation and that you feel you will be able to commit to financially.
Ask each lender you meet for a key fact sheet. This will aid you in comparing rates, fees and features.
This will provide you information like:
- The loan terms
- The current mortgage rates for rental properties
- Repayment dates and methods
- Establishment fees
- Set up fees
- Total to be repaid – including principle, interest and added fees
- What happens if you want to repay your loan faster
- What to expect when interest rates increase or decrease
Try to be as specific as you can with your lender. This will help them provide you with information tailored to your specific situation, so that there are no unexpected surprises.
There you have it. You now have a few basic ideas and concepts to consider and get you started on your journey to buying your first investment property.
Remember to be diligent and make decisions based on the facts about your situation and not your emotions.
Following your heart may have helped you find the love of your life, but it makes for a terrible financial adviser.