Finding the cash to put down a deposit is a continuing problem for property buyers, particularly first time buyers and investors.
This has led to an increase in lenders providing higher risk loans in order to gain market share – in particular loans where loan-to-value ratios (LVR) are higher than 80%.
According to the Australian Prudential Regulatory Authority (APRA), more than a third of new lending had a LVR higher than 80% in the quarter ending March 2014, while 13% of bank loans and 17% of loans from non-bank lenders had LVR’s or 90% or more.
The APRA has recently expressed its concern about the level of risk and loan quality lenders are prepared to take on in order to gain market share (read my article ‘Borrowing woes continue’ for more details on this), and lenders are being encouraged to avoid increasing their loan books by lowering their lending standards.
In light of this, I think it is also important to consider whether it is good for borrowers to take on higher LVR loans.
I have always advocated that buyers should contribute a decent deposit, which I think should be around the 20% mark and no less than 10%. This view seems to be shared by APRA, at least from a macro perspective.
However, coming up with a 20% deposit is tough enough when house prices are relatively stable, but now that prices are on the rise, the ability to save a decent deposit is getting further out of reach for more and more aspiring property owners.
The property market is currently present us with what I would call a perfect storm. There are increasing property prices at a time when interest rates are low (both generally considered good things), at the same time as more stringent lending guidelines are coming in to play (considered prudent).
This, combined with other factors like increasing demand and lack of supply, is locking more and more people out of the property market because they cannot bridge the deposit gap.
In today’s perfect storm environment, there may be occasions where a smaller deposit may be the only option for many borrowers. While this is not ideal, it may still be a reasonable approach.
Judging by current lending volumes (one in three new loans are at or above 80% LVR, and around one in eight are above 90% LVR), the reality that many home buyers and investors are struggling to save a decent deposit is loud and clear.
It’s also worth mentioning that the days of no deposit purchases are gone, and I say good riddance to them. 100% mortgages were a disaster for many borrowers who over-committed and found themselves in financial difficulties with no equity to cushion them when financial problems hit.
This left many people with negative equity (often from day one) and in a lot of trouble when they couldn’t meet their mortgage repayments.
So, is a low deposit loan a good thing?
Let’s define a low deposit loan as one where the deposit is under 10% of the purchase price and would typically sit around the 5% mark.
To put this into context for you, the table below compares the different deposit requirements for a $400,000 property. It is pretty clear that the lower the deposit the quicker and easier it is to enter the market.
Table 1: Different deposit requirements for a $400,000 property.
There are mixed views on the merits of taking out a low deposit loan, so let’s explore the pros and cons of the situation.
What’s in it for borrowers?
- It helps buyers enter the market sooner.
- Buyers can enjoy the upside of subsequent price increases, including building their equity as property prices go up, rather than falling victim to a growing deposit gap which increases alongside property price growth.
- Most low deposit loan products come with the same features as mainstream loans, so borrowers aren’t disadvantaged as far as choice is concerned.
- Low cost loans tend to be more expensive with things such as the interest rate, fees and Lenders Mortgage Insurance, and have much tighter underwriting criteria – especially for the self-employed.
- Low deposit loans have much higher default rates, which is significantly to both the lender and borrower.
If things go wrong early in the loan, major financial problems such as negative can follow.
- Rating agencies like Moody’s and Standard and Poor’s don’t like these types of loans because of their risk profile. These agencies tend to give low deposit loans a lower credit rating. Lenders don’t like this as it adversely effects investor and shareholder expectations, and increases their borrowing costs and investors require a higher return.
What’s in it for lenders?
Given the downside risk, why do lenders want to be active in the low deposit loan market? In simple terms, it’s because there’s money to be made.
Typically lenders enter this market to:
- Gain market share.
- Establish a market niche.
- Enhance profitability.
So, how do lenders mitigate their risks? By doing the following:
- Transferring their potential losses to third parties like Lenders Mortgage Insurance providers, guarantors and taking extra or additional security (such as over a second property or other assets).
- Introducing tougher lending guidelines including credit scoring (usually at the request of insurers) and excluding/limiting certain types of borrowers.
- Charging more and using the extra income to cover any losses.
So, is a low deposit loan right for you?
In an ideal world the answer is probably no. But the reality is, coming up with a 20% deposit (or more) is getting harder and harder as property price continue to rise.
So, with some hesitation, a low deposit could be the right option so long as you stick to the following guidelines:
1. Make sure the loan is affordable
Borrowing beyond your means is never an option regardless of how much equity you have.
2. Choose a reputable lender
Only borrow from someone you know and trust. Make sure the lender understands and has empathy with low deposit borrowers, and has a positive track record with this type of lending.
3. Know the conditions of the loan
Don’t allow your loan to limit you because you are contributing a lower deposit. Make sure the loan’s terms and features are the same as those available to borrowers with larger deposits.
4. Find a competitive interest rate
Costs and the interest rate should be comparable to mainstream loans. They may be slightly higher as you have a lower deposit, but they should not be significantly higher.
If you’re paying above standard rates, once you show you can meet repayments with no issues and you have built up equity, you should look to renegotiate your interest rate or refinance.
5. Build up equity
Ensure your loan allows you to make accelerated or lump sum payments when possible, without incurring any additional fees, with the aim of getting your equity to at least 10% as quickly as possible.
Your aim is to get yourself in a comfortable equity position as soon as possible so you have a buffer in case things go wrong.
To read my top tips to help ensure you have the best chance of getting your home or investment loan approved, click here.