Would you lend money to yourself?
With our property markets gearing up for another good year more investors are looking at their borrowing capacity to see how much the banks will lend them.
So what exactly do the banks look for when assessing your loan application?
In the good old days money was readily available and the banks looked for reasons to approve as many loans as possible.
Now they’re still keen to lend money, but they're much more careful who they lend it to.
As a result, they have dusted off the long-standing rule books on loan assessments and are once again referring to what is known as the “Four C’s” of lending.
When banks refer to an applicant’s character, they are essentially looking at that person’s credit history.
In other words;
• How stable is their employment?
• How stable are their living arrangements?
• What type of loans have they sought and been approved for in the past?
• How long did it take them to repay their debts?
• Did they default (miss payments) on any loans?
• Are there any judgments against them with regard to bad debts?
• Were they always on time with their repayments or did they drag their feet?
• How many credit inquiries have they made and over what timeframe?
All of these factors that go toward determining an applicant’s character are assessed using the individual’s credit file.
Everyone who has ever applied for any type of finance, be it a credit card, mobile phone account, personal loan or home loan has a credit file registered against their name
Whenever you apply for credit, the credit assessor will obtain your credit file and from this document, work out whether you have a good or bad credit rating or history – this tells them all about your lending “character”.
Lenders want to know that you have the capacity to pay them back – with some form of stable employment and income, and how well you honour your loan commitments – do you pay your debts on time and in full?
Basically they want to make sure that they will get their money back.
Your credit file is run by a company called Veda Advantage.
The good news is you can go to their website www.mycreditfile.com.au to request a copy of your credit file, which outlines things like;
• Any loans you have applied for in the past 10 to 15 years
• References to bad credit you may have had in the past seven years
• Bankruptcies or judgments
• Current and historic directorships in companies
• Past residential addresses
• Historical employment data
In other words, it makes you pretty much transparent to the bank, with your credit file telling a fairly detailed story about your behavior in the credit world.
All lenders and mortgage insurance companies have access to this file and when applying for a loan, you give them authority to delve into your credit history. This is one of the very first steps in the assessment process.
Many people like to “shop around” for a good deal when it comes to securing credit.
They like to think they are getting the best interest rate or product.
The problem with this is it can damage your credit rating and financial character.
If you have applied for numerous loans within the last six to twelve months, such multiple inquiries are a red flag to credit assessors; particularly if all the inquiries are for the same amount.
Even though there may be a legitimate reason for this activity, such as shopping around to find a good deal, lenders simply perceive you as a high risk applicant.
Their interpretation is that you must have been knocked back by all of the various lenders you approached and then they might start digging deeper to find out why.
Or worse still, may just decide to decline you without any further investigation.
If you have four to six inquiries on your credit file within the past six months, the banks will perceive you as a bad credit risk and deny you funding.
One of the best ways to avoid this outcome is to engage the services of a good finance broker to do the shopping around on your behalf.
They can help you secure the best deal possible on interest rates, fees and charges.
More importantly, you will get the best product for your specific circumstances and you won’t have multiple inquiries on your credit file.
If you do have multiple inquiries on your file for good reason – such as attempting to secure the best deal – I would suggest putting this in writing to the lender to give you a better chance at proving your credit worthiness.
We’ve all been guilty of missing a payment or two on our utility bills or monthly credit card statements.
The problem is when that late payment is recorded on your credit file as a default the banks take it very seriously.
About a year or so ago, lenders showed some flexibility and would consider a written explanation for your tardy payment to Telstra, as long as it was adequate.
Such reasons as relocating and forgetting to tell the credit provider could mean the bank would be willing to disregard your oversight.
Today though, it’s a very different ball game.
If you have a small unpaid or even paid default for a phone bill, the lender will be less likely to approve your application.
My advice would be to pay all of your debts on time, every time whenever possible.
If for some reason you can’t, contact the credit provider immediately to discuss a payment arrangement rather than waiting until they start chasing you.
You should also check your credit file before applying for any type of loan to make sure there are no glitches that could harm your chances of obtaining credit.
When it comes to the banks assessing your lending character, your employment history will be closely scrutinized.
People who have jumped from job to job in the past 12 months are seen as high risk by lenders, whereas applicants who have remained with the same employer for three to five years are looked upon much more favourably.
Banks are also less willing to give funds to people who have just started in a new position where there is a probationary period.
For this reason, if you are planning to purchase your first property, upgrade, or access equity in existing property(s) to build an investment portfolio, it’s always advisable to apply for a loan before changing jobs.
Normally you would also require two years worth of completed financials now that low doc and no doc loans have virtually been outlawed.
This includes the balance sheet and profit and loss statement prepared by your accountant, your income tax return and notice of assessment.
If you are self employed and two years worth of full financials are yet to be completed, lenders will request a copy of 6 to 12 months worth of bank statements and 3 to 6 months worth of trading account statements.
This enables them to calculate how much income you could derive from your business.
The second “C” of credit is collateral; what you are offering the lender as security over your loan.
For investors or home buyers, this would be some type of property.
Lenders favour certain properties over others when it comes to assessing a loan application.
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Is the collateral you are offering them a 15 square metre bedsitter or is it a four bedroom mansion in a blue chip suburb?
Something like student accommodation or a small one bed apartment is not considered preferred security by the banks, meaning you might be limited in regard to the loan you can get, if they will even give you one at all.
They may only be willing to look at a maximum Loan to Value Ratio (LVR) of 65 to 70%, the loan could come with a higher interest rate, the loan term could be reduced from 30 to 20 years and it is unlikely you would be offered an interest only product.
So it is critical, as an investor, to really be aware of this particular assessment criterion when considering the type of property you are planning on adding to your portfolio
Another factor is location.
A property in a blue chip suburb in one of our metropolitan cities is far more attractive to lenders than real estate in regional or rural Australia.
Essentially, the banks are so stringent with their assessment of the size, type and location of the property you intend to use as collateral because for them it comes down to the question of how much they can get if everything goes pear shaped and they are forced to sell the asset.
This situation is known as a fire sale
When you can no longer make your repayments, the bank must put your property on the market to recoup their funds, which they aim to do within 30 days.
Hence, they assess your collateral’s potential risk on that basis, meaning if they think the property will be difficult to sell or will only fetch a very low price they will not want to give you a loan on that property.
This means that for investors with limited funds, you would be better off purchasing a smaller one bedroom apartment in a prime inner city location, as opposed to a one bedroom apartment in a country town, because nine times out of ten the lender would assess the first example much more favourably than the latter.
To them, this represents more attractive collateral.
Your capacity to repay the loan is the third “C” and is commonly referred to as serviceability; where the bank looks at your employment income, either PAYG or self-employed, any rental income and all of your assets and liabilities.
The way banks assess your employment income is pretty self explanatory.
They simply look at how much you have coming in each month and deduct from that how much you have going out for things like general living expenses (groceries, rent or mortgage, utilities, etc), personal loans and credit card debts.
One important aspect to note with regard to credit and store cards is that the higher your credit limits, the less capacity you have to meet your loan commitments in the eyes of the banks
I always suggest that clients reduce their credit card limit wherever possible.
We often see clients with up to $50,000 or even $70,000 credit card limits, but this can work against them because when it comes to the way the banks asses your serviceability and how much they will lend you, your existing credit limits makes a big difference.
For instance, a $20,000 or $25,000 credit card limit may reduce the amount you can borrow by as much as $70,000 or $80,000.
When it comes to assessing rental income from an investment portfolio, lenders’ policies can vary significantly.
A handful of lenders might be willing to take into account 100% of your rental income when considering your level of serviceability.
On the other hand, many of the big banks will limit the amount of rental income that goes toward their assessment of your ability to service the loan to as little as 75% or even 65%.
The reason some lenders look less favourably on rental income is that it’s not seen as stable earnings
They will factor in variables that can cause rental income to go up or down, such as vacancy periods, property management and insurance costs and things like maintenance and repairs.
Although this may not seem like a significant issue, think about it this way; if you have a property portfolio generating a rental income of $100,000 per annum and one bank uses that entire $100,000 to asses your ability to service your loans, whereas another bank uses only $75,000, that means you have a gap in your borrowing capacity of nearly $350,000 at current interest rates.
Essentially, this difference could mean that by borrowing from the bank who allows a more generous assessment of your rental income (at 100%), you are able to buy one extra property to add to your investment portfolio.
The fourth and final “C” is Capital; your deposit.
This is also often referred to as the Loan to Value Ratio (LVR).
If you are seeking an 80% LVR or lower (meaning you have a 20% plus deposit), then credit is relatively easy to come by.
However if the LVR exceeds 80%, then the application has to be submitted to a mortgage insurer and they are currently very risk adverse.
One of the biggest stumbling blocks when it comes to assessment of a property investment loan application is cross collateralization of securities.
This occurs when you start off with one bank and one loan, then you go out and buy a second property with further funding from the same bank, who then ties the two properties together as one security; known as cross collateral.
In other words, they’re holding security for all loans across all properties.
Now let’s move forward and assume you want to buy a third property.
Perhaps one of your properties has increased in value, but the second has flat lined.
If you have both properties tied up in a cross collateral situation, you may not be able to access any equity at all, even though the first property has produced sufficient growth to give you a decent amount of leveragability.
Of course if the properties were not cross collateralized, you could access the equity from the property that did increase in value.
We often see this with clients who have cross collateralized securities with the big four banks.
Recently a client was told that she couldn’t access more funds as the bank was not willing to increase their exposure to her.
She wanted to add more properties to her portfolio, so she removed the cross collateral.
As a result, she was able to purchase another five properties.
The final consideration for investors when it comes to how banks will assess your loan application is the structure of your portfolio.
The bottom line is, not all banks like to lend to every type of structure.
So it is important to understand the structure you will be using, whose names will be on the loan documents and who is on title.
Is the loan in an individual names or in your trust name?
Is the trustee company or another entity on the title?
This is very important to clarify with your broker because if they don’t know what type of structure you intend to purchase your investments in, they can’t apply for the right loan and select the right bank from word go.
ensuring you present the lender with an application that is impossible to reject based on their specific assessment criteria
By doing so, you have a far better chance of securing that all important finance to build a lucrative property investment portfolio and meet your wealth creation goals.
• Avoid cross collateralizing your loans.
• Use multiple banks in the right order, because that could possibly allow you to borrow enough to buy one more property.
• Buy the right type of property – one that the bank sees as a good investment.
• Maintain a good credit rating, protect your credit rating and check your credit score. Reduce your credit limit to give you more serviceability.
• Avoid multiple applications and inquiries that will impact your credit rating.
• Show a history of stable employment and stay in the same industry for a while if you can
• For the self-employed, make sure you have an ABN number.