All investing comes down to two considerations: risk and return.
Ideally, you want to eliminate risk and maximise return.
It doesn’t matter what type of investment you’re considering: buying property, buying shares, fixed interest deposits, small business, foreign exchange trading, you name it – these two key principles of risk and return govern how successful you’ll be.
For property investors, consideration of the loan to value ratio (LVR) plays a crucial role in determining the risk and return potential.
The widely held belief is that the higher the LVR, the higher the risk. But the reverse can actually be true in some cases.
If you buy a $500,000 property and have a $400,000 mortgage, then you need a $100,000 deposit.
20% of the property’s value is the deposit and 80% is the loan.
The value of the property is $500k and the value of the loan is $400k.
So the loan to value ratio, or LVR for short, is 400,000 / 500,000 = 0.8 or 80%.
In other words, the loan to value ratio is the ratio of the size of the loan in dollars to the value of the property in dollars.
The LVR is usually expressed as a percentage.
Bad stuff happens
Imagine if you bought a $500,000 property with a 100% LVR.
Now imagine you can’t make interest payments and the lender sells the property to recoup their losses.
If the property has dropped by as little as 10%, the lender will only get $450,000 out of their $500,000 back.
They’ve made a $50,000 loss, which no doubt they’ll have to chase you for and it will cost them even more to do that chasing.
Now imagine you bought that same $500k property but this time with an 80% LVR.
With a smaller loan, you’re paying less interest, but let’s assume you still can’t make ends meet.
The lender would sell the property for $450k and there would be another $50,000 left over to pay for legal fees, the agent’s commission and any other loss they may have incurred.
You can see that a lender wants the lowest LVR they can get to minimise their risk.
High LVR risk ironies
It’s a popularly held belief that the higher the LVR, the higher the risk.
This is certainly the case from the lender’s perspective.
But from the investors side, it is not necessarily so.
Example 1 – diversification
If you only have $100,000 available for a 20% deposit on a $500,000 property, you’re putting all your eggs in one basket buying that one property.
If you’ve picked the wrong market or got the timing wrong, you may be holding it for a long time before seeing any growth.
If you instead bought two $450,000 properties with a 90% LVR, you could buy these two properties in completely different markets.
Then you would have reduced your investment risk by diversifying.
There’s more chance one of those markets you picked was an astute choice.
Example 2 – emergency money
Let’s say you’re eyeing off a $500k property and you have the $100k deposit ready but you don’t have much left over to cover stamp duty and legal fees.
There’s enough in the account, but only just.
This is a pretty risky position to be in.
If something happens to the property after settlement like a nightmare tenant or the discovery of some structural fault, you’re not in a position to cover the costs.
If you lose your job, you need time to find another.
Having emergency money on hand is vital for keeping your property from being sold by the lender.
Taking the higher LVR option actually reduces your risk because now you’ll have excess funds on hand for these types of emergency.
Example 3 – value adding
As in the case with example 2, if you have some money left over after the purchase you can perform some renovations to both add value to the property and increase its yield.
This may put you in a safer position than if you had put all your deposit into a lower LVR loan product.
It all comes down to how much value you can add with your renovation and how much extra rental income it will generate.
If you spent $40,000 for example on the renovation and it added a measly $60,000 in value that’s a 50% return on investment – pretty good.
And if the renovation added an extra $60 per week to the rental income, that equates to an extra $3,000 per year.
That’s a cash-on-cash return on investment of 7.5%.
It’s nothing flash, but it’s better than money in the bank.
If either of these two things happen, or better, then I’d say that $40k was better spent on the reno than on the deposit.
Should I go high LVR?
The first question that needs to be answered is whether you can go high LVR.
Once your mortgage broker has gone over your financials, ask for a range of loan products with varying LVRs.
If you have no option, then the discussion is moot.
Can you sacrifice other loan features?
Note that there may be high LVR products available but at a cost of losing some other beneficial feature.
Perhaps the high LVR products aren’t available for buying in trusts or perhaps they come with a heavier interest bill or you have to pay principle and interest instead of interest only.
It depends on the strategy of the investor and their financial circumstances to know precisely which features are worth giving up for a high LVR.
Do you have a small deposit?
If you simply don’t have the funds to put down a 20% deposit, then a high LVR may be your only option.
But have you considered cheaper locations or cheaper properties within the same location?
If you’re sure you’ve found the best location and the best property in that location and you can’t afford a 20% deposit, by all means go down the high LVR path.
If you’ve found a well-priced property in a decent growth spot, then you’re better off jumping in than trying to save a bigger deposit.
Once you’re in the market you’re moving with it rather than chasing after it.
Do you have good cash flow?
Make sure your cash flow is pretty strong if you’re choosing high LVR.
You don’t want to be forced to sell.
The lender or mortgage insurer will look over your financials with a microscope anyway.
Just don’t try to make your case appear better than it really is.
Are you sure of short-term growth?
If things do go pear-shaped and you need to liquidate in a hurry you want the market you’ve bought in to have some capital growth already.
You need to be confident of where prices are heading in the immediate future, that is, before you start to default on loan payments.
Will you fit into a high LVR risk irony?
Can you create a case like one of the examples I mentioned earlier in the section on High risk LVR ironies?
Will a higher LVR free up some cash you can put to good use?
You could perform some value adding renovation soon after settlement to create some equity breathing space.
Keep in mind you can’t claim that renovation as repairs and maintenance if it is straight after settlement.
So this option is not very tax effective.
An easier option, especially if renovations aren’t your thing is to get instant equity at settlement from buying off the plan.
This is on the assumption that capital growth occurs between contract exchange and settlement.
And an even better option would be to buy at cost price if you can develop – actively or passively.
You get the benefits of growth prior to settlement as with the off the plan option and the instant equity from acquiring at cost price.
Remember that if you can afford a high LVR loan, your serviceability is pretty good.
That may mean you’re paying too much tax.
So a new property with greater depreciation benefits like off the plan or passive development may be a better choice than renovating.
Do you want to diversify?
As I mentioned earlier, you can almost double your buying potential by halving the deposit.
That means maybe two properties at higher LVR.
So long as you choose completely different property markets to invest in, this can be a good idea.
Do you want to maximise ROI?
I’m a bit of a data nut-job.
I love spreadsheet analysis too.
Every property I buy, I put together a spreadsheet listing the injection of capital and the ongoing costs and income.
I try to project capital growth too.
The bottom line is what I’m interested in – the ROI or Return on Investment.
If I pay stamp duty, legal fees and a deposit of $100,000, then I want a good return on that investment.
If all goes according to plan, invariably this ROI figure is much larger with high LVR loans than with low LVR loans.
In fact, my number one goal when I first started buying property was to find the loan with the highest LVR.
Even when interest rates got up to 9%, the ROI was still better with a high LVR than with a low one.
The simple spreadsheet in table 1 shows the ROI for an imaginary property with an LVR of 80%.
Table 2 shows the ROI for the same property with a 90% LVR.
In the ROI spreadsheets I’ve left out consideration of depreciation since this will be the same in both high and low LVR cases and it keeps the spreadsheets simple.
Have a look at which option gives the best return on your investment.
It’s the high LVR option despite paying more interest and the extra cost of LMI.
Note that there is not much point in choosing a high LVR product simply to make a spreadsheet look good and to say you have a high ROI.
If you aren’t going to put to use the excess funds a high LVR frees up, then you may as well go for the low LVR option.
Note that there is about $40,000 excess funds left over for the high LVR option of spreadsheet 2.
You can save some of that for emergencies and spend some of it on renovations.
Or you could buy another cheaper property maybe.
A high LVR loan suits most investment strategies.
However, the ability to source such loans for some strategies is a little more difficult than for others.
Many lenders will not be interested in offering high LVR loans for developments or to purchase regional property or property in locations where there may be over-supply or significant exposure to that lender already.
Remember that a high LVR spells trouble to a lender, so they want the lowest risk property as security.
Depreciation of the LMI payable for a high LVR loan can be claimed over five years.
If your strategy is for a shorter term, it may be considered a waste to pay the premium.
Check with your accountant concerning your specific plan for the property.
You may be able to write off the full amount for short term projects.
There may also be a chance you can claim back from the insurer the LMI premium if you sell the property soon after purchase like for a renovation flip.
Check with your mortgage broker or ask mortgage insurers directly.
It is probably safer to use a low LVR loan rather than a high LVR product for short term projects.
Can I keep going with high LVR?
No. Eventually, you’re going to have to drop your LVR requirements.
There are a few reasons:
- The extra debt increases the interest cost and you’ll have trouble servicing the debt
- The high degree of leverage makes you a high risk to lenders
- You will run out of mortgage insurers
- Eventually you’ll want to retire on your portfolio and this won’t be positively geared at such high LVR
Should I go low LVR?
Assuming you have the deposit funds to do so, a low LVR gives you a few positives:
- Lower debt means more sleep at night
- Lower debt means lower interest payments
- Lower debt means you’re more attractive to future lenders
- Lower debt means you’re closer to an LVR suitable for retirement
Any unusual or higher risk investment strategy would suit a low LVR loan.
The standard 80% LVR suits most property investment strategies.
Large developments may require an even lower LVR.
The lower the LVR, the more lenders you’ll find and the more flexible they’ll be.
So if there is anything unorthodox about your strategy, low LVR is for you.
Depending on your serviceability you may have no choice but to go for a low LVR loan.
That doesn’t mean you’re not going to make as much of a profit, it just means the injection of funds you need to get that profit is larger.
What is more important than LVR choice is the choice of location and type of property you purchase.
And maybe what you plan to do with it too.
Don’t let the lack of choices for loan products stop you from making great investments.
Getting in the market early any way you can is better than getting in late with the perfect loan.